Investors Can Find Comfort In Solomon Systech (International)'s (HKG:2878) Earnings Quality

The market was pleased with the recent earnings report from Solomon Systech (International) Limited (HKG:2878), despite the profit numbers being soft. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

Check out our latest analysis for Solomon Systech (International)

Zooming In On Solomon Systech (International)'s 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to December 2023, Solomon Systech (International) had an accrual ratio of -0.31. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of US$37m, well over the US$19.4m it reported in profit. Solomon Systech (International)'s free cash flow improved over the last year, which is generally good to see.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Solomon Systech (International).

Our Take On Solomon Systech (International)'s Profit Performance

As we discussed above, Solomon Systech (International)'s accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Solomon Systech (International)'s statutory profit actually understates its earnings potential! And the EPS is up 65% annually, over the last three years. 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. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example - Solomon Systech (International) has 1 warning sign we think you should be aware of.

This note has only looked at a single factor that sheds light on the nature of Solomon Systech (International)'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. 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.