The market for CETC Chips Technology Inc.'s (SHSE:600877) stock was strong after it released a healthy earnings report last week. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

Zooming In On CETC Chips 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 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.

CETC Chips Technology has an accrual ratio of 0.21 for the year to March 2024. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Over the last year it actually had negative free cash flow of CN¥79m, in contrast to the aforementioned profit of CN¥234.9m. It's worth noting that CETC Chips Technology generated positive FCF of CN¥98m a year ago, so at least they've done it in the past.

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

Our Take On CETC Chips Technology's Profit Performance

CETC Chips Technology's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that CETC Chips Technology's true underlying earnings power is actually less than its statutory profit. But at least holders can take some solace from the 15% per annum growth in EPS for the last three. 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 CETC Chips Technology at this point in time. While conducting our analysis, we found that CETC Chips Technology has 1 warning sign and it would be unwise to ignore it.

Today we've zoomed in on a single data point to better understand the nature of CETC Chips Technology's profit. 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 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.