Leo Group's (SZSE:002131) Earnings Might Not Be As Promising As They Seem

The healthy profit announcement from Leo Group Co., Ltd. (SZSE:002131 ) didn't seem to impress investors. We think that they may be worried about something else, so we did some analysis and found that investors have noticed some soft numbers underlying the profit.

View our latest analysis for Leo Group

Examining Cashflow Against Leo Group'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. 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 March 2024, Leo Group recorded an accrual ratio of 0.28. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥1.9b despite its profit of CN¥1.13b, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥1.9b, this year, indicates high risk. 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 Leo Group.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥154m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. Leo Group had a rather significant contribution from unusual items relative to its profit to March 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Leo Group's Profit Performance

Summing up, Leo Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Leo Group's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Leo Group, you'd also look into what risks it is currently facing. When we did our research, we found 2 warning signs for Leo Group (1 is significant!) that we believe deserve your full attention.

Our examination of Leo Group 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 are plenty of other ways to inform your opinion of a company. 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 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.