Test-Rite International's (TWSE:2908) Weak Earnings May Only Reveal A Part Of The Whole Picture

A lackluster earnings announcement from Test-Rite International Co., Ltd. (TWSE:2908) last week didn't sink the stock price. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

See our latest analysis for Test-Rite International

Zooming In On Test-Rite 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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 March 2024, Test-Rite International recorded an accrual ratio of -0.10. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of NT$2.0b in the last year, which was a lot more than its statutory profit of NT$227.4m. Notably, Test-Rite International had negative free cash flow last year, so the NT$2.0b it produced this year was a welcome improvement. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Test-Rite International.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Test-Rite International profited from a tax benefit which contributed NT$52m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. Of course, prima facie it's great to receive a tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Test-Rite International's Profit Performance

While Test-Rite International's accrual ratio stands testament to its strong cashflow, and indicates good quality earnings, the fact that it received a tax benefit suggests that this year's profit may not be a great guide to its sustainable profit run-rate. Given the contrasting considerations, we don't have a strong view as to whether Test-Rite International's profits are an apt reflection of its underlying potential for profit. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Our analysis shows 2 warning signs for Test-Rite International (1 makes us a bit uncomfortable!) and we strongly recommend you look at these bad boys before investing.

Our examination of Test-Rite International has focussed on certain factors that can make its earnings look better than they are. 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. 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.