Jiujiang Shanshui Technology Co.,Ltd (SZSE:301190) announced strong profits, but the stock was stagnant. We did some digging, and we found some concerning factors in the details.

Examining Cashflow Against Jiujiang Shanshui TechnologyLtd'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2024, Jiujiang Shanshui TechnologyLtd had an accrual ratio of 0.35. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Over the last year it actually had negative free cash flow of CN¥150m, in contrast to the aforementioned profit of CN¥80.5m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥150m, this year, indicates high risk. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Jiujiang Shanshui TechnologyLtd.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Jiujiang Shanshui TechnologyLtd saw its profit reduced by unusual items worth CN¥9.5m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Jiujiang Shanshui TechnologyLtd to produce a higher profit next year, all else being equal.

Our Take On Jiujiang Shanshui TechnologyLtd's Profit Performance

In conclusion, Jiujiang Shanshui TechnologyLtd's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, we think it's very unlikely that Jiujiang Shanshui TechnologyLtd's statutory profits make it seem much weaker than it is. So while earnings quality is important, it's equally important to consider the risks facing Jiujiang Shanshui TechnologyLtd at this point in time. Be aware that Jiujiang Shanshui TechnologyLtd is showing 3 warning signs in our investment analysis and 2 of those are a bit unpleasant...

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.