Shareholders appeared unconcerned with New Media Lab Limited's (HKG:1284) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.

Zooming In On New Media Lab'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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 June 2024, New Media Lab recorded an accrual ratio of -0.24. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of HK$30m during the period, dwarfing its reported profit of HK$18.2m. New Media Lab's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons.

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

Our Take On New Media Lab's Profit Performance

Happily for shareholders, New Media Lab produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that New Media Lab's statutory profit actually understates its earnings potential! On the other hand, its EPS actually shrunk in the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Case in point: We've spotted 4 warning signs for New Media Lab you should be mindful of and 1 of these bad boys is potentially serious.

Today we've zoomed in on a single data point to better understand the nature of New Media Lab's profit. 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 with significant insider holdings 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.