Weak Statutory Earnings May Not Tell The Whole Story For GKG Precision Machine (SZSE:301338)

Following the release of a lackluster earnings report from GKG Precision Machine Co., Ltd. (SZSE:301338) the stock price made a strong positive move. We looked at the details, and we think that investors may be responding to some encouraging factors.

View our latest analysis for GKG Precision Machine

Examining Cashflow Against GKG Precision Machine'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2024, GKG Precision Machine had an accrual ratio of 0.48. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥74m despite its profit of CN¥51.8m, mentioned above. It's worth noting that GKG Precision Machine generated positive FCF of CN¥57m a year ago, so at least they've done it in the past. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of GKG Precision Machine.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) GKG Precision Machine saw its profit reduced by unusual items worth CN¥4.4m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. 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, after all, that's exactly what the accounting terminology implies. If GKG Precision Machine doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that GKG Precision Machine profited from a tax benefit which contributed CN¥2.2m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! We're sure the company was pleased with its tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On GKG Precision Machine's Profit Performance

In conclusion, GKG Precision Machine's accrual ratio suggests that its statutory earnings are not backed by cash flow, in part due to the tax benefit it received; but the fact unusual items actually weighed on profit may create upside if those unusual items do not recur. Based on these factors, we think that GKG Precision Machine's statutory profits probably make it seem better than it is on an underlying level. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To help with this, we've discovered 4 warning signs (2 are significant!) that you ought to be aware of before buying any shares in GKG Precision Machine.

Our examination of GKG Precision Machine has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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.