Changchun FAWAY Automobile ComponentsLtd's (SHSE:600742) Soft Earnings Don't Show The Whole Picture

Investors were disappointed with the weak earnings posted by Changchun FAWAY Automobile Components Co.,Ltd (SHSE:600742 ). Despite the soft profit numbers, our analysis has optimistic about the overall quality of the income statement.

View our latest analysis for Changchun FAWAY Automobile ComponentsLtd

A Closer Look At Changchun FAWAY Automobile ComponentsLtd'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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Changchun FAWAY Automobile ComponentsLtd has an accrual ratio of -0.30 for the year to September 2024. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥1.4b in the last year, which was a lot more than its statutory profit of CN¥488.4m. Changchun FAWAY Automobile ComponentsLtd 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 Changchun FAWAY Automobile ComponentsLtd.

The Impact Of Unusual Items On Profit

While the accrual ratio might bode well, we also note that Changchun FAWAY Automobile ComponentsLtd's profit was boosted by unusual items worth CN¥58m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If Changchun FAWAY Automobile ComponentsLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Changchun FAWAY Automobile ComponentsLtd's Profit Performance

Changchun FAWAY Automobile ComponentsLtd's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think that Changchun FAWAY Automobile ComponentsLtd's profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into Changchun FAWAY Automobile ComponentsLtd, you'd also look into what risks it is currently facing. For example, we've found that Changchun FAWAY Automobile ComponentsLtd has 2 warning signs (1 is concerning!) that deserve your attention before going any further with your analysis.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.