We Believe Qingci Games' (HKG:6633) Earnings Are A Poor Guide For Its Profitability

We didn't see Qingci Games Inc.'s (HKG:6633) stock surge when it reported robust earnings recently. We think that investors might be worried about the foundations the earnings are built on.

View our latest analysis for Qingci Games

Examining Cashflow Against Qingci Games' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2023, Qingci Games recorded an accrual ratio of 0.73. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. Indeed, in the last twelve months it reported free cash flow of CN¥55m, which is significantly less than its profit of CN¥167.4m. We note, however, that Qingci Games grew its free cash flow over the last year. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. One positive for Qingci Games shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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?

The fact that the company had unusual items boosting profit by CN¥29m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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 that's as you'd expect, given these boosts are described as 'unusual'. If Qingci Games doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Qingci Games' Profit Performance

Summing up, Qingci Games received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Qingci Games' statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. In terms of investment risks, we've identified 1 warning sign with Qingci Games, and understanding it should be part of your investment process.

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.