Hengdian Group DMEGC Magnetics Ltd's (SZSE:002056) Earnings May Just Be The Starting Point

Even though Hengdian Group DMEGC Magnetics Co. ,Ltd's (SZSE:002056) recent earnings release was robust, the market didn't seem to notice. Our analysis suggests that investors might be missing some promising details.

Check out our latest analysis for Hengdian Group DMEGC Magnetics Ltd

Zooming In On Hengdian Group DMEGC Magnetics Ltd's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

For the year to December 2023, Hengdian Group DMEGC Magnetics Ltd had an accrual ratio of -0.11. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of CN¥2.2b during the period, dwarfing its reported profit of CN¥1.82b. Hengdian Group DMEGC Magnetics Ltd's free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the 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?

Hengdian Group DMEGC Magnetics Ltd's profit was reduced by unusual items worth CN¥408m 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. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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 Hengdian Group DMEGC Magnetics Ltd to produce a higher profit next year, all else being equal.

Our Take On Hengdian Group DMEGC Magnetics Ltd's Profit Performance

Considering both Hengdian Group DMEGC Magnetics Ltd's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Hengdian Group DMEGC Magnetics Ltd's earnings potential is at least as good as it seems, and maybe even better! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. At Simply Wall St, we found 1 warning sign for Hengdian Group DMEGC Magnetics Ltd and we think they deserve your attention.

Our examination of Hengdian Group DMEGC Magnetics Ltd has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.

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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.