Nanjing LES Information Technology Co., Ltd.'s (SHSE:688631 ) stock didn't jump after it announced some healthy earnings. We think that investors might be worried about some concerning underlying factors.

A Closer Look At Nanjing LES 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). 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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Nanjing LES Information Technology has an accrual ratio of 0.23 for the year to September 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of CN¥135.6m, a look at free cash flow indicates it actually burnt through CN¥61m in the last year. We also note that Nanjing LES Information Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥61m. 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?

Given the accrual ratio, it's not overly surprising that Nanjing LES Information Technology's profit was boosted by unusual items worth CN¥29m 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. And, after all, that's exactly what the accounting terminology implies. Nanjing LES 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 Nanjing LES Information Technology's Profit Performance

Nanjing LES Information Technology had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Nanjing LES Information Technology's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Nanjing LES Information Technology as a business, it's important to be aware of any risks it's facing. You'd be interested to know, that we found 2 warning signs for Nanjing LES Information Technology and you'll want to know about them.

Our examination of Nanjing LES Information Technology 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.