Shanghai Wisdom Information Technology Co., Ltd.'s (SZSE:301315) solid earnings report last week was underwhelming to investors. Our analysis has found some underlying factors which may be cause for concern.

Zooming In On Shanghai Wisdom Information Technology's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to September 2024, Shanghai Wisdom Information Technology recorded an accrual ratio of 0.30. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥62.2m, a look at free cash flow indicates it actually burnt through CN¥2.9m in the last year. We saw that FCF was CN¥33m a year ago though, so Shanghai Wisdom Information Technology has at least been able to generate positive FCF 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shanghai Wisdom Information Technology.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥20m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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. Shanghai Wisdom Information Technology had a rather significant contribution from unusual items relative to its profit to September 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Shanghai Wisdom Information Technology's Profit Performance

Summing up, Shanghai Wisdom Information Technology 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 Shanghai Wisdom Information Technology'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 Shanghai Wisdom Information Technology at this point in time. When we did our research, we found 3 warning signs for Shanghai Wisdom Information Technology (2 are concerning!) that we believe deserve your full attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.