Espressif Systems (Shanghai) Co., Ltd.'s (SHSE:688018) robust earnings report didn't manage to move the market for its stock. Our analysis suggests that shareholders have noticed something concerning in the numbers.

A Closer Look At Espressif Systems (Shanghai)'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Espressif Systems (Shanghai) has an accrual ratio of -0.11 for the year to December 2023. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of CN¥253m during the period, dwarfing its reported profit of CN¥136.2m. Espressif Systems (Shanghai)'s free cash flow improved over the last year, which is generally good to see. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Espressif Systems (Shanghai)'s profit was boosted by unusual items worth CN¥14m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If Espressif Systems (Shanghai) doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Espressif Systems (Shanghai) received a tax benefit of CN¥31m. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Espressif Systems (Shanghai)'s Profit Performance

Summing up, Espressif Systems (Shanghai)'s accrual ratio suggests that its statutory earnings are well matched by free cash flow while its unusual items and tax benefit is boosted profit in a way that may not be sustained. For the reasons mentioned above, we think that a perfunctory glance at Espressif Systems (Shanghai)'s statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. You'd be interested to know, that we found 1 warning sign for Espressif Systems (Shanghai) and you'll want to know about this.

Our examination of Espressif Systems (Shanghai) 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 is always more to discover if you are capable of focussing your mind on minutiae. 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.