China Display Optoelectronics Technology Holdings Limited (HKG:334) announced strong profits, but the stock was stagnant. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

View our latest analysis for China Display Optoelectronics Technology Holdings

Zooming In On China Display Optoelectronics Technology Holdings' 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. 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.

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. 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.

For the year to June 2022, China Display Optoelectronics Technology Holdings had an accrual ratio of 8.08. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of CN¥21m during the period, falling well short of its reported profit of CN¥229.6m. China Display Optoelectronics Technology Holdings' free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. The good news for shareholders is that China Display Optoelectronics Technology Holdings' 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 China Display Optoelectronics Technology Holdings.

Our Take On China Display Optoelectronics Technology Holdings' Profit Performance

As we have made quite clear, we're a bit worried that China Display Optoelectronics Technology Holdings didn't back up the last year's profit with free cashflow. For this reason, we think that China Display Optoelectronics Technology Holdings' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you want to do dive deeper into China Display Optoelectronics Technology Holdings, you'd also look into what risks it is currently facing. Case in point: We've spotted 1 warning sign for China Display Optoelectronics Technology Holdings you should be aware of.

Today we've zoomed in on a single data point to better understand the nature of China Display Optoelectronics Technology Holdings' 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.