CSP Inc. (NASDAQ:CSPI) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

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

CSP has an accrual ratio of -0.24 for the year to December 2023. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of US$9.5m during the period, dwarfing its reported profit of US$3.91m. Notably, CSP had negative free cash flow last year, so the US$9.5m it produced this year was a welcome improvement. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation.

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

An Unusual Tax Situation

Moving on from the accrual ratio, we note that CSP profited from a tax benefit which contributed US$589k to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. Of course, prima facie it's great to receive a tax benefit. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On CSP's Profit Performance

In conclusion, CSP has strong cashflow relative to earnings, which indicates good quality earnings, but the tax benefit means its profit wasn't as sustainable as we'd like to see. Based on these factors, it's hard to tell if CSP's profits are a reasonable reflection of its underlying profitability. If you'd like to know more about CSP as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 2 warning signs for CSP you should be aware of.

Our examination of CSP has focussed on certain factors that can make its earnings look better than they are. 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.