ChengDu Hi-Tech Development's (SZSE:000628) Earnings Are Of Questionable Quality

Last week's profit announcement from ChengDu Hi-Tech Development Co., Ltd. (SZSE:000628) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

See our latest analysis for ChengDu Hi-Tech Development

Zooming In On ChengDu Hi-Tech Development's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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.

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. 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 December 2023, ChengDu Hi-Tech Development had an accrual ratio of 0.65. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥827m, in contrast to the aforementioned profit of CN¥365.9m. We saw that FCF was CN¥76m a year ago though, so ChengDu Hi-Tech Development has at least been able to generate positive FCF in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of ChengDu Hi-Tech Development.

Our Take On ChengDu Hi-Tech Development's Profit Performance

As we have made quite clear, we're a bit worried that ChengDu Hi-Tech Development didn't back up the last year's profit with free cashflow. For this reason, we think that ChengDu Hi-Tech Development's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The silver lining is that its EPS growth over the last year has been really wonderful, even if it's not a perfect measure. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing ChengDu Hi-Tech Development at this point in time. While conducting our analysis, we found that ChengDu Hi-Tech Development has 2 warning signs and it would be unwise to ignore these.

This note has only looked at a single factor that sheds light on the nature of ChengDu Hi-Tech Development's profit. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.