The market seemed underwhelmed by last week's earnings announcement from Linhai Co.,Ltd. (SHSE:600099) despite the healthy numbers. Our analysis suggests that shareholders might be missing some positive underlying factors in the earnings report.

Examining Cashflow Against LinhaiLtd'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). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the 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. 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 December 2023, LinhaiLtd recorded an accrual ratio of -0.37. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥126m in the last year, which was a lot more than its statutory profit of CN¥13.3m. LinhaiLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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

Our Take On LinhaiLtd's Profit Performance

As we discussed above, LinhaiLtd's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think LinhaiLtd's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. 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. Just as investors must consider earnings, it is also important to take into account the strength of a company's balance sheet. If you're interested we have a graphic representation of LinhaiLtd's balance sheet.

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