The recent earnings posted by Friend Co.,Ltd. (SHSE:605050) were solid, but the stock didn't move as much as we expected. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

Examining Cashflow Against FriendLtd'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. 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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

FriendLtd has an accrual ratio of 0.39 for the year to December 2023. 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. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥830m despite its profit of CN¥417.3m, mentioned above. We also note that FriendLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥830m.

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.

Our Take On FriendLtd's Profit Performance

As we discussed above, we think FriendLtd's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that FriendLtd's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 21% EPS growth in the last year. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, FriendLtd has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of FriendLtd'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. 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.