Essence Information Technology Co., Ltd.'s (SHSE:688555) recent weak earnings report didn't cause a big stock movement. We think that investors are worried about some weaknesses underlying the earnings.

Check out our latest analysis for Essence Information Technology

Zooming In On Essence Information Technology'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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Essence Information Technology has an accrual ratio of 0.47 for the year to March 2022. 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. Even though it reported a profit of CN¥17.5m, a look at free cash flow indicates it actually burnt through CN¥237m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥237m, this year, indicates high risk.

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

Our Take On Essence Information Technology's Profit Performance

As we discussed above, we think Essence Information Technology's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Essence Information Technology's underlying earnings power is lower than its statutory profit. In further bad news, its earnings per share decreased 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. If you'd like to know more about Essence Information Technology as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 4 warning signs for Essence Information Technology (of which 2 are a bit unpleasant!) you should know about.

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