We Believe That Wuhan Lincontrol Automotive Electronics' (SHSE:688667) Weak Earnings Are A Good Indicator Of Underlying Profitability

Wuhan Lincontrol Automotive Electronics Co., Ltd.'s (SHSE:688667) lackluster earnings announcement last week disappointed investors. We think that they may have more to worry about than just soft profit numbers.

See our latest analysis for Wuhan Lincontrol Automotive Electronics

Zooming In On Wuhan Lincontrol Automotive Electronics' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to December 2023, Wuhan Lincontrol Automotive Electronics recorded an accrual ratio of 0.21. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥161m, in contrast to the aforementioned profit of CN¥49.1m. We also note that Wuhan Lincontrol Automotive Electronics' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥161m. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this 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?

Given the accrual ratio, it's not overly surprising that Wuhan Lincontrol Automotive Electronics' profit was boosted by unusual items worth CN¥11m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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. We can see that Wuhan Lincontrol Automotive Electronics' positive unusual items were quite significant relative to its profit in the year to December 2023. 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 Wuhan Lincontrol Automotive Electronics received a tax benefit of CN¥8.9m. 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 Wuhan Lincontrol Automotive Electronics' Profit Performance

Summing up, Wuhan Lincontrol Automotive Electronics' tax benefit and unusual items boosted its statutory profit leading to poor cash conversion, as reflected by its accrual ratio. For all the reasons mentioned above, we think that, at a glance, Wuhan Lincontrol Automotive Electronics' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So while earnings quality is important, it's equally important to consider the risks facing Wuhan Lincontrol Automotive Electronics at this point in time. For example, Wuhan Lincontrol Automotive Electronics has 3 warning signs (and 1 which is potentially serious) we think you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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 that insiders are buying 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.