Investors Can Find Comfort In SEC Electric Machinery's (SHSE:603988) Earnings Quality

SEC Electric Machinery Co., Ltd.'s (SHSE:603988) earnings announcement last week didn't impress shareholders. However, our analysis suggests that the soft headline numbers are getting counterbalanced by some positive underlying factors.

Check out our latest analysis for SEC Electric Machinery

A Closer Look At SEC Electric Machinery'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. 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.

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. 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. 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, SEC Electric Machinery recorded an accrual ratio of -0.12. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of CN¥80m during the period, dwarfing its reported profit of CN¥16.5m. Given that SEC Electric Machinery had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥80m would seem to be a step in the right direction. However, that's not all there is to consider. 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 SEC Electric Machinery.

How Do Unusual Items Influence Profit?

SEC Electric Machinery's profit was reduced by unusual items worth CN¥8.5m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If SEC Electric Machinery doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On SEC Electric Machinery's Profit Performance

Considering both SEC Electric Machinery's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that SEC Electric Machinery's underlying earnings power is at least as good as the statutory numbers would make it seem. If you want to do dive deeper into SEC Electric Machinery, you'd also look into what risks it is currently facing. For example, SEC Electric Machinery has 3 warning signs (and 1 which is significant) we think you should know about.

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