Statutory Profit Doesn't Reflect How Good China Security's (SHSE:600654) Earnings Are

China Security Co., Ltd. (SHSE:600654) just reported healthy earnings but the stock price didn't move much. We think that investors have missed some encouraging factors underlying the profit figures.

See our latest analysis for China Security

Examining Cashflow Against China Security'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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. 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 March 2024, China Security recorded an accrual ratio of -0.22. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of CN¥338m during the period, dwarfing its reported profit of CN¥117.0m. Notably, China Security had negative free cash flow last year, so the CN¥338m it produced this year was a welcome improvement.

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

Our Take On China Security's Profit Performance

Happily for shareholders, China Security produced plenty of free cash flow to back up its statutory profit numbers. Because of this, we think China Security's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And one can definitely find a positive in the fact that it made a profit this year, despite losing money last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. While earnings are important, another area to consider is the balance sheet. You can see our latest analysis on China Security's balance sheet health here.

Today we've zoomed in on a single data point to better understand the nature of China Security's profit. 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.