Impressive Earnings May Not Tell The Whole Story For Espressif Systems (Shanghai) (SHSE:688018)

Despite posting some strong earnings, the market for Espressif Systems (Shanghai) Co., Ltd.'s (SHSE:688018) stock hasn't moved much. We did some digging, and we found some concerning factors in the details.

Check out our latest analysis for Espressif Systems (Shanghai)

Examining Cashflow Against Espressif Systems (Shanghai)'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. The ratio shows us how much a company's profit exceeds its FCF.

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".

Over the twelve months to December 2023, Espressif Systems (Shanghai) recorded an accrual ratio of -0.11. Therefore, its statutory earnings were quite a lot less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of CN¥253m, well over the CN¥136.2m it reported in profit. Espressif Systems (Shanghai) shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

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.

How Do Unusual Items Influence Profit?

Surprisingly, given Espressif Systems (Shanghai)'s accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥14m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. If Espressif Systems (Shanghai) doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Espressif Systems (Shanghai) profited from a tax benefit which contributed CN¥31m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. 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.

Our Take On Espressif Systems (Shanghai)'s Profit Performance

In conclusion, Espressif Systems (Shanghai)'s accrual ratio suggests its earnings are well backed by cash but its boost from unusual items, and a tax benefit, probably mean that the statutory number make the company seem more profitable than it is at an underlying level. Considering all this we'd argue Espressif Systems (Shanghai)'s profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Espressif Systems (Shanghai), you'd also look into what risks it is currently facing. You'd be interested to know, that we found 1 warning sign for Espressif Systems (Shanghai) and you'll want to know about this.

Our examination of Espressif Systems (Shanghai) 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. 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.