Guandian Defense Technology Co.,Ltd.'s (SHSE:688287) stock rose after its recent weak earnings report. Sometimes, shareholders are willing to ignore soft numbers with the hope that they will improve, but our analysis suggests this is unlikely for Guandian Defense TechnologyLtd.

See our latest analysis for Guandian Defense TechnologyLtd

Examining Cashflow Against Guandian Defense TechnologyLtd'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

Guandian Defense TechnologyLtd has an accrual ratio of 0.54 for the year to June 2022. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥267.4m, a look at free cash flow indicates it actually burnt through CN¥6.3m in the last year. We also note that Guandian Defense TechnologyLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥6.3m. The good news for shareholders is that Guandian Defense TechnologyLtd'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 Guandian Defense TechnologyLtd.

Our Take On Guandian Defense TechnologyLtd's Profit Performance

As we have made quite clear, we're a bit worried that Guandian Defense TechnologyLtd didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Guandian Defense TechnologyLtd's underlying earnings power is lower than its statutory profit. But the good news is that its EPS growth over the last three years has been very impressive. 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. If you want to do dive deeper into Guandian Defense TechnologyLtd, you'd also look into what risks it is currently facing. At Simply Wall St, we found 1 warning sign for Guandian Defense TechnologyLtd and we think they deserve your attention.

This note has only looked at a single factor that sheds light on the nature of Guandian Defense TechnologyLtd'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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.