Investors Can Find Comfort In Prime Oil Chemical Service's (TWSE:2904) Earnings Quality

Soft earnings didn't appear to concern Prime Oil Chemical Service Corporation's (TWSE:2904) shareholders over the last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

View our latest analysis for Prime Oil Chemical Service

Zooming In On Prime Oil Chemical Service'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. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2024, Prime Oil Chemical Service recorded an accrual ratio of -0.11. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of NT$236m during the period, dwarfing its reported profit of NT$75.1m. Prime Oil Chemical Service's free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Prime Oil Chemical Service.

The Impact Of Unusual Items On Profit

Prime Oil Chemical Service's profit was reduced by unusual items worth NT$13m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Prime Oil Chemical Service to produce a higher profit next year, all else being equal.

Our Take On Prime Oil Chemical Service's Profit Performance

Considering both Prime Oil Chemical Service's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that Prime Oil Chemical Service's underlying earnings power is at least as good as the statutory numbers would make it seem. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, Prime Oil Chemical Service has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.

After our examination into the nature of Prime Oil Chemical Service's profit, we've come away optimistic for the company. 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 with significant insider holdings 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.