Flowing Cloud Technology's (HKG:6610) Shareholders Have More To Worry About Than Only Soft Earnings

Flowing Cloud Technology Ltd's (HKG:6610) stock showed strength, with investors undeterred by its weak earnings report. While shareholders may be willing to overlook soft profit numbers, we believe that they should also be taking into account some other factors which may be cause for concern.

See our latest analysis for Flowing Cloud Technology

A Closer Look At Flowing Cloud Technology'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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2024, Flowing Cloud Technology recorded an accrual ratio of 0.37. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥250m, in contrast to the aforementioned profit of CN¥211.1m. We also note that Flowing Cloud Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥250m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Flowing Cloud Technology.

Our Take On Flowing Cloud Technology's Profit Performance

As we have made quite clear, we're a bit worried that Flowing Cloud Technology didn't back up the last year's profit with free cashflow. For this reason, we think that Flowing Cloud Technology's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But the good news is that its EPS growth over the last three years has been very impressive. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you want to do dive deeper into Flowing Cloud Technology, you'd also look into what risks it is currently facing. To help with this, we've discovered 2 warning signs (1 makes us a bit uncomfortable!) that you ought to be aware of before buying any shares in Flowing Cloud Technology.

This note has only looked at a single factor that sheds light on the nature of Flowing Cloud Technology's profit. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.