Shareholders Can Be Confident That XJ Electric's (SZSE:000400) Earnings Are High Quality

The subdued stock price reaction suggests that XJ Electric Co., Ltd.'s (SZSE:000400) strong earnings didn't offer any surprises. Investors are probably missing some underlying factors which are encouraging for the future of the company.

See our latest analysis for XJ Electric

A Closer Look At XJ Electric'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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".

For the year to March 2024, XJ Electric had an accrual ratio of -0.25. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥2.9b during the period, dwarfing its reported profit of CN¥1.08b. XJ Electric shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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.

Our Take On XJ Electric's Profit Performance

Happily for shareholders, XJ Electric produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that XJ Electric's statutory profit actually understates its earnings potential! And the EPS is up 47% annually, over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing XJ Electric at this point in time. For example - XJ Electric has 1 warning sign we think you should be aware of.

This note has only looked at a single factor that sheds light on the nature of XJ Electric's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 that insiders are buying.

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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.