Solomon Systech (International) Limited's (HKG:2878) robust earnings report didn't manage to move the market for its stock. Our analysis suggests that shareholders have noticed something concerning in the numbers.

See our latest analysis for Solomon Systech (International)

A Closer Look At Solomon Systech (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. 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.

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".

For the year to December 2021, Solomon Systech (International) had an accrual ratio of 1.11. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of US$23.8m, a look at free cash flow indicates it actually burnt through US$7.5m in the last year. We saw that FCF was US$33m a year ago though, so Solomon Systech (International) has at least been able to generate positive FCF in the past. The good news for shareholders is that Solomon Systech (International)'s 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Solomon Systech (International).

Our Take On Solomon Systech (International)'s Profit Performance

As we discussed above, we think Solomon Systech (International)'s earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Solomon Systech (International)'s statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But the happy news is that, while acknowledging we have to look beyond the statutory numbers, those numbers are still improving, with EPS growing at a very high rate over 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. Every company has risks, and we've spotted 2 warning signs for Solomon Systech (International) (of which 1 doesn't sit too well with us!) you should know about.

This note has only looked at a single factor that sheds light on the nature of Solomon Systech (International)'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.