We Don’t Think Microware Group's (HKG:1985) Earnings Should Make Shareholders Too Comfortable

Microware Group Limited (HKG:1985) posted some decent earnings, but shareholders didn't react strongly. We think that they might be concerned about some underlying details that our analysis found.

See our latest analysis for Microware Group

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

Microware Group has an accrual ratio of 0.61 for the year to September 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of HK$36.9m, a look at free cash flow indicates it actually burnt through HK$45m in the last year. It's worth noting that Microware Group generated positive FCF of HK$105m a year ago, so at least they've done it in the past. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Microware Group'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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Microware Group.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Microware Group's profit was boosted by unusual items worth HK$4.6m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. If Microware Group doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Microware Group's Profit Performance

Microware Group had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Microware Group's profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, we've found that Microware Group has 4 warning signs (2 are a bit unpleasant!) that deserve your attention before going any further with your analysis.

Our examination of Microware Group has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.