Matrix Design's (SZSE:301365) Conservative Accounting Might Explain Soft Earnings

Matrix Design Co., Ltd.'s (SZSE:301365) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. However, we think the company is showing some signs that things are more promising than they seem.

Check out our latest analysis for Matrix Design

Examining Cashflow Against Matrix Design's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. 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.

For the year to March 2024, Matrix Design had an accrual ratio of -0.23. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of CN¥100m during the period, dwarfing its reported profit of CN¥21.7m. Matrix Design shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Matrix Design.

How Do Unusual Items Influence Profit?

Matrix Design's profit was reduced by unusual items worth CN¥6.8m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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. Assuming those unusual expenses don't come up again, we'd therefore expect Matrix Design to produce a higher profit next year, all else being equal.

Our Take On Matrix Design's Profit Performance

Considering both Matrix Design's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon Matrix Design's statutory profit probably understates its earnings potential! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example - Matrix Design has 3 warning signs we think you should be aware of.

After our examination into the nature of Matrix Design's profit, we've come away optimistic for the company. 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.