Taiwan Environment Scientific's (TWSE:8476) Weak Earnings May Only Reveal A Part Of The Whole Picture

The subdued market reaction suggests that Taiwan Environment Scientific Co., Ltd.'s (TWSE:8476) recent earnings didn't contain any surprises. We think that investors are worried about some weaknesses underlying the earnings.

Check out our latest analysis for Taiwan Environment Scientific

A Closer Look At Taiwan Environment Scientific'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. This ratio tells us how much of a company's profit is not backed by free cashflow.

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".

Taiwan Environment Scientific has an accrual ratio of 0.34 for the year to December 2023. 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. In the last twelve months it actually had negative free cash flow, with an outflow of NT$261m despite its profit of NT$362.6m, mentioned above. We also note that Taiwan Environment Scientific's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of NT$261m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Taiwan Environment Scientific.

Our Take On Taiwan Environment Scientific's Profit Performance

As we have made quite clear, we're a bit worried that Taiwan Environment Scientific didn't back up the last year's profit with free cashflow. For this reason, we think that Taiwan Environment Scientific's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Sadly, its EPS was down over the last twelve months. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 2 warning signs for Taiwan Environment Scientific (1 is concerning!) that we believe deserve your full attention.

Today we've zoomed in on a single data point to better understand the nature of Taiwan Environment Scientific's profit. 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. 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.