Solid profit numbers didn't seem to be enough to please Keystone Electrical (Zhejiang) Co.,Ltd.'s (SZSE:301448) shareholders. We think that they might be concerned about some underlying details that our analysis found.

Zooming In On Keystone Electrical (Zhejiang)Ltd's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Keystone Electrical (Zhejiang)Ltd has an accrual ratio of 0.56 for the year to September 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of CN¥48m, in contrast to the aforementioned profit of CN¥66.3m. It's worth noting that Keystone Electrical (Zhejiang)Ltd generated positive FCF of CN¥102m a year ago, so at least they've done it in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for Keystone Electrical (Zhejiang)Ltd shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Keystone Electrical (Zhejiang)Ltd.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Keystone Electrical (Zhejiang)Ltd's profit was boosted by unusual items worth CN¥9.9m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. If Keystone Electrical (Zhejiang)Ltd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Keystone Electrical (Zhejiang)Ltd's Profit Performance

Summing up, Keystone Electrical (Zhejiang)Ltd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Keystone Electrical (Zhejiang)Ltd's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Keystone Electrical (Zhejiang)Ltd at this point in time. To that end, you should learn about the 3 warning signs we've spotted with Keystone Electrical (Zhejiang)Ltd (including 2 which are significant).

Our examination of Keystone Electrical (Zhejiang)Ltd has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. Some people consider a high return on equity to be a good sign of a quality business. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.