The subdued stock price reaction suggests that Qingdao Copton Technology Company Limited's (SHSE:603798) strong earnings didn't offer any surprises. Our analysis suggests that investors might be missing some promising details.

Zooming In On Qingdao Copton 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. 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. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to September 2024, Qingdao Copton Technology had an accrual ratio of -0.19. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥183m during the period, dwarfing its reported profit of CN¥57.2m. Notably, Qingdao Copton Technology had negative free cash flow last year, so the CN¥183m it produced this year was a welcome improvement.

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

Our Take On Qingdao Copton Technology's Profit Performance

As we discussed above, Qingdao Copton Technology's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Qingdao Copton Technology's statutory profit actually understates its earnings potential! And the EPS is up 16% over the last twelve months. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Qingdao Copton Technology at this point in time. When we did our research, we found 2 warning signs for Qingdao Copton Technology (1 makes us a bit uncomfortable!) that we believe deserve your full attention.

This note has only looked at a single factor that sheds light on the nature of Qingdao Copton Technology's profit. 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. 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.

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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.