A lackluster earnings announcement from Chen Lin Education Group Holdings Limited (HKG:1593) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.

Examining Cashflow Against Chen Lin Education Group Holdings' 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.

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. 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".

Over the twelve months to August 2024, Chen Lin Education Group Holdings recorded an accrual ratio of 0.23. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥406m, in contrast to the aforementioned profit of CN¥15.4m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥406m, this year, indicates high risk. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Chen Lin Education Group Holdings.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Chen Lin Education Group Holdings' profit was boosted by unusual items worth CN¥22m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Chen Lin Education Group Holdings' Profit Performance

Summing up, Chen Lin Education Group Holdings 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 Chen Lin Education Group Holdings' 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 Chen Lin Education Group Holdings at this point in time. To that end, you should learn about the 4 warning signs we've spotted with Chen Lin Education Group Holdings (including 3 which can't be ignored).

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.

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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.