Shanghai Information2 Software Inc.'s (SHSE:688435) lackluster earnings announcement last week disappointed investors. We looked deeper and believe that there is even more to be worried about, beyond the soft profit numbers.

Examining Cashflow Against Shanghai Information2 Software's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. 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.

Shanghai Information2 Software has an accrual ratio of 0.20 for the year to September 2024. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥8.46m, a look at free cash flow indicates it actually burnt through CN¥39m in the last year. We also note that Shanghai Information2 Software's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥39m. 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 Information2 Software.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Shanghai Information2 Software's profit was boosted by unusual items worth CN¥12m in the last twelve months. 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. Which is hardly surprising, given the name. We can see that Shanghai Information2 Software's positive unusual items were quite significant relative to its profit in the year to September 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Shanghai Information2 Software's Profit Performance

Summing up, Shanghai Information2 Software received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Shanghai Information2 Software's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Shanghai Information2 Software as a business, it's important to be aware of any risks it's facing. Be aware that Shanghai Information2 Software is showing 3 warning signs in our investment analysis and 2 of those are significant...

Our examination of Shanghai Information2 Software 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 are plenty of other ways to inform your opinion of a company. 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.