SIM Technology Group's (HKG:2000) Earnings Are Built On Soft Foundations

Shareholders didn't seem to be thrilled with SIM Technology Group Limited's (HKG:2000) recent earnings report, despite healthy profit numbers. We think that they might be concerned about some underlying details that our analysis found.

Check out our latest analysis for SIM Technology Group

A Closer Look At SIM Technology 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. 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.

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 December 2023, SIM Technology Group recorded an accrual ratio of 0.35. 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. Even though it reported a profit of HK$344.3m, a look at free cash flow indicates it actually burnt through HK$19m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of HK$19m, this year, indicates high risk. 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 SIM Technology 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 SIM Technology Group.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that SIM Technology Group's profit was boosted by unusual items worth HK$519m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. SIM Technology Group had a rather significant contribution from unusual items relative to its profit to December 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On SIM Technology Group's Profit Performance

Summing up, SIM Technology Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at SIM Technology Group's statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. When we did our research, we found 2 warning signs for SIM Technology Group (1 shouldn't be ignored!) that we believe deserve your full attention.

Our examination of SIM Technology 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 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 that insiders are buying.

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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.