The stock price didn't jump after Southchip Semiconductor Technology(Shanghai) Co., Ltd. (SHSE:688484) posted decent earnings last week. We did some digging and believe investors may be worried about some underlying factors in the report.

Zooming In On Southchip Semiconductor Technology(Shanghai)'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). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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".

Over the twelve months to December 2023, Southchip Semiconductor Technology(Shanghai) recorded an accrual ratio of 0.59. 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. Over the last year it actually had negative free cash flow of CN¥97m, in contrast to the aforementioned profit of CN¥261.4m. It's worth noting that Southchip Semiconductor Technology(Shanghai) generated positive FCF of CN¥302m a year ago, so at least they've done it in the past. The good news for shareholders is that Southchip Semiconductor Technology(Shanghai)'s accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. 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.

Our Take On Southchip Semiconductor Technology(Shanghai)'s Profit Performance

As we discussed above, we think Southchip Semiconductor Technology(Shanghai)'s earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Southchip Semiconductor Technology(Shanghai)'s statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. 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. So while earnings quality is important, it's equally important to consider the risks facing Southchip Semiconductor Technology(Shanghai) at this point in time. Our analysis shows 2 warning signs for Southchip Semiconductor Technology(Shanghai) (1 is a bit unpleasant!) and we strongly recommend you look at them before investing.

Today we've zoomed in on a single data point to better understand the nature of Southchip Semiconductor Technology(Shanghai)'s profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.