The market was pleased with the recent earnings report from Rongan Property Co.,Ltd. (SZSE:000517), despite the profit numbers being soft. However, we think the company is showing some signs that things are more promising than they seem.

A Closer Look At Rongan PropertyLtd's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to December 2023, Rongan PropertyLtd had an accrual ratio of -0.17. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥2.4b during the period, dwarfing its reported profit of CN¥357.5m. Rongan PropertyLtd's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, that's not all there is to consider. 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 Rongan PropertyLtd.

How Do Unusual Items Influence Profit?

Rongan PropertyLtd's profit was reduced by unusual items worth CN¥1.2b in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. In the twelve months to December 2023, Rongan PropertyLtd had a big unusual items expense. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Rongan PropertyLtd's Profit Performance

In conclusion, both Rongan PropertyLtd's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Rongan PropertyLtd's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So while earnings quality is important, it's equally important to consider the risks facing Rongan PropertyLtd at this point in time. When we did our research, we found 4 warning signs for Rongan PropertyLtd (1 shouldn't be ignored!) that we believe deserve your full attention.

Our examination of Rongan PropertyLtd has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.

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.