Nanjing Xinlian Electronics' (SZSE:002546) Conservative Accounting Might Explain Soft Earnings

Nanjing Xinlian Electronics Co., Ltd's (SZSE:002546) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

Check out our latest analysis for Nanjing Xinlian Electronics

A Closer Look At Nanjing Xinlian Electronics' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. 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 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 September 2024, Nanjing Xinlian Electronics had an accrual ratio of -0.31. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥281m during the period, dwarfing its reported profit of CN¥51.9m. Nanjing Xinlian Electronics shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Nanjing Xinlian Electronics.

The Impact Of Unusual Items On Profit

Nanjing Xinlian Electronics' profit was reduced by unusual items worth CN¥57m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. In the twelve months to September 2024, Nanjing Xinlian Electronics had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On Nanjing Xinlian Electronics' Profit Performance

Considering both Nanjing Xinlian Electronics' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon Nanjing Xinlian Electronics' statutory profit probably understates its earnings potential! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For instance, we've identified 4 warning signs for Nanjing Xinlian Electronics (1 can't be ignored) you should be familiar with.

After our examination into the nature of Nanjing Xinlian Electronics' profit, we've come away optimistic for the company. 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. 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 with significant insider holdings 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.