GrandiT Co., Ltd.'s (SHSE:688549) stock rose after it released a robust earnings report. Despite the strong profit numbers, we believe that there are some deeper issues which investors should look into.

A Closer Look At GrandiT'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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to March 2024, GrandiT recorded an accrual ratio of 0.21. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥277m despite its profit of CN¥22.5m, mentioned above. We also note that GrandiT's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥277m. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that GrandiT's profit was boosted by unusual items worth CN¥34m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. We can see that GrandiT's positive unusual items were quite significant relative to its profit in the year to March 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On GrandiT's Profit Performance

GrandiT had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue GrandiT's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into GrandiT, you'd also look into what risks it is currently facing. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of GrandiT.

Our examination of GrandiT has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there are plenty of other ways to inform your opinion of a company. 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.