The market for Design Capital Limited's (HKG:1545) shares didn't move much after it posted weak earnings recently. We did some digging, and we believe the earnings are stronger than they seem.

A Closer Look At Design Capital'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. 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. 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Design Capital has an accrual ratio of -0.50 for the year to June 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of S$15m during the period, dwarfing its reported profit of S$2.49m. Design Capital 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 Design Capital.

Our Take On Design Capital's Profit Performance

Happily for shareholders, Design Capital produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Design Capital's statutory profit actually understates its earnings potential! On the other hand, its EPS actually shrunk in the last twelve months. 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. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Our analysis shows 3 warning signs for Design Capital (1 is concerning!) and we strongly recommend you look at these before investing.

This note has only looked at a single factor that sheds light on the nature of Design Capital's profit. 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.