The market for Shenzhen SNC Opto Electronic Co.,Ltd's (SZSE:001326) stock was strong after it released a healthy earnings report last week. While the profit numbers were good, our analysis has found some concerning factors that shareholders should be aware of.

A Closer Look At Shenzhen SNC Opto ElectronicLtd'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. 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. 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".

Shenzhen SNC Opto ElectronicLtd has an accrual ratio of 0.43 for the year to December 2023. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of CN¥71m in the last year, which was a lot less than its statutory profit of CN¥153.3m. Shenzhen SNC Opto ElectronicLtd shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shenzhen SNC Opto ElectronicLtd.

Our Take On Shenzhen SNC Opto ElectronicLtd's Profit Performance

As we discussed above, we think Shenzhen SNC Opto ElectronicLtd's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Shenzhen SNC Opto ElectronicLtd's underlying earnings power is lower than its statutory profit. The good news is that, its earnings per share increased by 11% in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. At Simply Wall St, we found 1 warning sign for Shenzhen SNC Opto ElectronicLtd and we think they deserve your attention.

Today we've zoomed in on a single data point to better understand the nature of Shenzhen SNC Opto ElectronicLtd's profit. 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. 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.