SMC Electric Limited's (HKG:2381) strong earnings report was rewarded with a positive stock price move. We did some digging and found some further encouraging factors that investors will like.

Examining Cashflow Against SMC Electric's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 June 2024, SMC Electric recorded an accrual ratio of -0.26. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of HK$36m in the last year, which was a lot more than its statutory profit of HK$20.7m. SMC Electric'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 SMC Electric.

Our Take On SMC Electric's Profit Performance

Happily for shareholders, SMC Electric produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that SMC Electric's statutory profit actually understates its earnings potential! Furthermore, it has done a great job growing EPS over 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For instance, we've identified 3 warning signs for SMC Electric (1 is concerning) you should be familiar with.

Today we've zoomed in on a single data point to better understand the nature of SMC Electric'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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.