Nanjing Xinlian Electronics Co., Ltd's (SZSE:002546) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. However, we think the company is showing some signs that things are more promising than they seem.

A Closer Look At Nanjing Xinlian Electronics' 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to September 2024, Nanjing Xinlian Electronics had an accrual ratio of -0.31. 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¥281m, well over the CN¥51.9m it reported in profit. Nanjing Xinlian Electronics shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. 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 Nanjing Xinlian Electronics.

How Do Unusual Items Influence Profit?

Nanjing Xinlian Electronics' profit was reduced by unusual items worth CN¥57m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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 that's hardly a surprise given these line items are considered unusual. In the twelve months to September 2024, Nanjing Xinlian Electronics had a big unusual items expense. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Nanjing Xinlian Electronics' Profit Performance

In conclusion, both Nanjing Xinlian Electronics' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Nanjing Xinlian Electronics' underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, we've found that Nanjing Xinlian Electronics has 4 warning signs (1 makes us a bit uncomfortable!) that deserve your attention before going any further with your analysis.

Our examination of Nanjing Xinlian Electronics has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.