Shanghai Qingpu Fire-Fighting Equipment's (HKG:8115) Robust Earnings Might Be Weaker Than You Think

Shanghai Qingpu Fire-Fighting Equipment Co., Ltd. (HKG:8115) posted some decent earnings, but shareholders didn't react strongly. We think that they might be concerned about some underlying details that our analysis found.

View our latest analysis for Shanghai Qingpu Fire-Fighting Equipment

Examining Cashflow Against Shanghai Qingpu Fire-Fighting Equipment's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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 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. 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 June 2022, Shanghai Qingpu Fire-Fighting Equipment had an accrual ratio of 1.15. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of CN¥6.6m during the period, falling well short of its reported profit of CN¥56.7m. Given that Shanghai Qingpu Fire-Fighting Equipment had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥6.6m would seem to be a step in the right direction. 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 Shanghai Qingpu Fire-Fighting Equipment.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥58m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. Which is hardly surprising, given the name. We can see that Shanghai Qingpu Fire-Fighting Equipment's positive unusual items were quite significant relative to its profit in the year to June 2022. 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 Shanghai Qingpu Fire-Fighting Equipment's Profit Performance

Shanghai Qingpu Fire-Fighting Equipment had a weak accrual ratio, but its profit did receive a boost from unusual items. For all the reasons mentioned above, we think that, at a glance, Shanghai Qingpu Fire-Fighting Equipment's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Be aware that Shanghai Qingpu Fire-Fighting Equipment is showing 2 warning signs in our investment analysis and 1 of those 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 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 that insiders are buying 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.