Unsurprisingly, Jikai Equipment Manufacturing Co., Ltd.'s (SZSE:002691) stock price was strong on the back of its healthy earnings report. However, our analysis suggests that shareholders may be missing some factors that indicate the earnings result was not as good as it looked.

Zooming In On Jikai Equipment Manufacturing'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Jikai Equipment Manufacturing has an accrual ratio of -0.13 for the year to June 2024. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of CN¥137m in the last year, which was a lot more than its statutory profit of CN¥21.3m. Given that Jikai Equipment Manufacturing had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥137m would seem to be a step in the right direction. 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 Jikai Equipment Manufacturing.

How Do Unusual Items Influence Profit?

Surprisingly, given Jikai Equipment Manufacturing's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥26m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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'. Jikai Equipment Manufacturing had a rather significant contribution from unusual items relative to its profit to June 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Jikai Equipment Manufacturing's Profit Performance

In conclusion, Jikai Equipment Manufacturing's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Having considered these factors, we don't think Jikai Equipment Manufacturing's statutory profits give an overly harsh view of the business. If you want to do dive deeper into Jikai Equipment Manufacturing, you'd also look into what risks it is currently facing. To help with this, we've discovered 3 warning signs (1 can't be ignored!) that you ought to be aware of before buying any shares in Jikai Equipment Manufacturing.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. 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 with significant insider holdings 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.