Shareholders appeared unconcerned with China MeiDong Auto Holdings Limited's (HKG:1268) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

Zooming In On China MeiDong Auto Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 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, China MeiDong Auto Holdings had an accrual ratio of -0.12. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of CN¥761m during the period, dwarfing its reported profit of CN¥74.2m. China MeiDong Auto Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

The Impact Of Unusual Items On Profit

China MeiDong Auto Holdings' profit was reduced by unusual items worth CN¥153m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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. Assuming those unusual expenses don't come up again, we'd therefore expect China MeiDong Auto Holdings to produce a higher profit next year, all else being equal.

Our Take On China MeiDong Auto Holdings' Profit Performance

In conclusion, both China MeiDong Auto Holdings' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Looking at all these factors, we'd say that China MeiDong Auto Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example - China MeiDong Auto Holdings has 2 warning signs we think you should be aware of.

After our examination into the nature of China MeiDong Auto Holdings' profit, we've come away optimistic for the company. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.