The market for FingerTango Inc.'s (HKG:6860) stock was strong after it released a healthy earnings report last week. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

A Closer Look At FingerTango'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. The ratio shows us how much a company's profit exceeds its FCF.

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 June 2024, FingerTango recorded an accrual ratio of 0.36. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥37.0m, a look at free cash flow indicates it actually burnt through CN¥11m 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¥11m, this year, indicates high risk. One positive for FingerTango shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

Our Take On FingerTango's Profit Performance

As we have made quite clear, we're a bit worried that FingerTango didn't back up the last year's profit with free cashflow. For this reason, we think that FingerTango's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The good news is that it earned a profit in the last twelve months, despite its previous loss. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing FingerTango at this point in time. To that end, you should learn about the 2 warning signs we've spotted with FingerTango (including 1 which is significant).

Today we've zoomed in on a single data point to better understand the nature of FingerTango'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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.