A lackluster earnings announcement from Gstarsoft Co., Ltd. (SHSE:688657) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

Zooming In On Gstarsoft's 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. 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. The ratio shows us how much a company's profit exceeds its FCF.

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

Over the twelve months to September 2024, Gstarsoft recorded an accrual ratio of -0.23. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥55m, well over the CN¥46.5m it reported in profit. Gstarsoft's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

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.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Gstarsoft's profit was boosted by unusual items worth CN¥6.4m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. We can see that Gstarsoft's positive unusual items were quite significant relative to its profit in the year to September 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Gstarsoft received a tax benefit of CN¥3.0m. 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. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. 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 Gstarsoft's Profit Performance

Summing up, Gstarsoft's accrual ratio suggests that its statutory earnings are well matched by free cash flow while its unusual items and tax benefit is boosted profit in a way that may not be sustained. Based on these factors, we think it's very unlikely that Gstarsoft's statutory profits make it seem much weaker than it is. If you'd like to know more about Gstarsoft as a business, it's important to be aware of any risks it's facing. You'd be interested to know, that we found 3 warning signs for Gstarsoft and you'll want to know about them.

Our examination of Gstarsoft 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. 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 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.