The recent earnings release from Guangdong Leadyo IC Testing Co., Ltd. (SHSE:688135 ) was disappointing to investors. We think there is more to the story than simply soft profit numbers. Our analysis shows that there are some other factors of concern.

Examining Cashflow Against Guangdong Leadyo IC Testing'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. 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'.

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 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. 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, Guangdong Leadyo IC Testing had an accrual ratio of 0.28. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥21.7m, a look at free cash flow indicates it actually burnt through CN¥366m 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¥366m, this year, indicates high risk. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Guangdong Leadyo IC Testing.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥12m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. Guangdong Leadyo IC Testing had a rather significant contribution from unusual items relative to its profit to December 2023. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Guangdong Leadyo IC Testing profited from a tax benefit which contributed CN¥15m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. We're sure the company was pleased with its tax benefit. 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 Guangdong Leadyo IC Testing's Profit Performance

Summing up, Guangdong Leadyo IC Testing's tax benefit and unusual items boosted its statutory profit leading to poor cash conversion, as reflected by its accrual ratio. For all the reasons mentioned above, we think that, at a glance, Guangdong Leadyo IC Testing's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 3 warning signs for Guangdong Leadyo IC Testing (2 are a bit unpleasant!) that we believe deserve your full attention.

Our examination of Guangdong Leadyo IC Testing 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 are plenty of other ways to inform your opinion of a company. 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 that insiders are buying.

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.