The market seemed underwhelmed by last week's earnings announcement from Chengdu Hongqi Chain Co.,Ltd. (SZSE:002697) despite the healthy numbers. Our analysis suggests that shareholders might be missing some positive underlying factors in the earnings report.

A Closer Look At Chengdu Hongqi ChainLtd'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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, Chengdu Hongqi ChainLtd had an accrual ratio of -0.35. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of CN¥1.3b in the last year, which was a lot more than its statutory profit of CN¥544.0m. Chengdu Hongqi ChainLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

Surprisingly, given Chengdu Hongqi ChainLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥86m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. If Chengdu Hongqi ChainLtd 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 Chengdu Hongqi ChainLtd's Profit Performance

Chengdu Hongqi ChainLtd's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think that Chengdu Hongqi ChainLtd's profits are a reasonably conservative guide to its underlying profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example - Chengdu Hongqi ChainLtd has 1 warning sign we think you should be aware of.

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. 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. 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.