Solid Earnings May Not Tell The Whole Story For 37 Interactive Entertainment Network Technology Group (SZSE:002555)

Following the solid earnings report from 37 Interactive Entertainment Network Technology Group Co., Ltd. (SZSE:002555), the market responded by bidding up the stock price. While the profit numbers were good, our analysis has found some concerning factors that shareholders should be aware of.

Check out our latest analysis for 37 Interactive Entertainment Network Technology Group

Examining Cashflow Against 37 Interactive Entertainment Network Technology Group'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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 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".

37 Interactive Entertainment Network Technology Group has an accrual ratio of 0.21 for the year to June 2024. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Indeed, in the last twelve months it reported free cash flow of CN¥1.4b, which is significantly less than its profit of CN¥2.70b. 37 Interactive Entertainment Network Technology Group's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. The good news for shareholders is that 37 Interactive Entertainment Network Technology Group's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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 37 Interactive Entertainment Network Technology Group's Profit Performance

37 Interactive Entertainment Network Technology Group didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that 37 Interactive Entertainment Network Technology Group's true underlying earnings power is actually less than its statutory profit. But at least holders can take some solace from the 36% per annum growth in EPS for the last three. 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 37 Interactive Entertainment Network Technology Group at this point in time. For example, 37 Interactive Entertainment Network Technology Group has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of 37 Interactive Entertainment Network Technology Group's profit. 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 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.