Xinhuanet Co., Ltd.'s (SHSE:603888) solid earnings announcement recently didn't do much to the stock price. Our analysis suggests that shareholders might be missing some positive underlying factors in the earnings report.

A Closer Look At Xinhuanet's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.

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

For the year to June 2024, Xinhuanet had an accrual ratio of -0.34. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of CN¥335m, well over the CN¥279.5m it reported in profit. Xinhuanet did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio.

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

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Xinhuanet received a tax benefit of CN¥70m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. Of course, prima facie it's great to receive a tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Xinhuanet's Profit Performance

While Xinhuanet's accrual ratio stands testament to its strong cashflow, and indicates good quality earnings, the fact that it received a tax benefit suggests that this year's profit may not be a great guide to its sustainable profit run-rate. Based on these factors, we think that Xinhuanet's profits are a reasonably conservative guide to its underlying profitability. If you'd like to know more about Xinhuanet as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 1 warning sign for Xinhuanet and we think they deserve your attention.

Our examination of Xinhuanet has focussed on certain factors that can make its earnings look better than they are. 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 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.