Hengdian Group DMEGC Magnetics Ltd's (SZSE:002056) Weak Earnings May Only Reveal A Part Of The Whole Picture

The market shrugged off Hengdian Group DMEGC Magnetics Co. ,Ltd's (SZSE:002056) weak earnings report last week. We did some analysis and found some positive factors that investors might be paying attention to rather than profit.

View our latest analysis for Hengdian Group DMEGC Magnetics Ltd

Examining Cashflow Against 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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 September 2024, Hengdian Group DMEGC Magnetics Ltd recorded an accrual ratio of 0.28. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Indeed, in the last twelve months it reported free cash flow of CN¥146m, which is significantly less than its profit of CN¥1.09b. Hengdian Group DMEGC Magnetics Ltd'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. 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. The good news for shareholders is that Hengdian Group DMEGC Magnetics Ltd'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. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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?

Unfortunately (in the short term) Hengdian Group DMEGC Magnetics Ltd saw its profit reduced by unusual items worth CN¥365m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If Hengdian Group DMEGC Magnetics Ltd doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

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

Hengdian Group DMEGC Magnetics Ltd saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Given the contrasting considerations, we don't have a strong view as to whether Hengdian Group DMEGC Magnetics Ltd's profits are an apt reflection of its underlying potential for profit. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, we've found that Hengdian Group DMEGC Magnetics Ltd has 3 warning signs (1 doesn't sit too well with us!) that deserve your attention before going any further with your analysis.

Our examination of Hengdian Group DMEGC Magnetics Ltd has focussed on certain factors that can make its earnings look better than they are. 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. 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.