SMC Electric Limited's (HKG:2381) healthy profit numbers didn't contain any surprises for investors. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

See our latest analysis for SMC Electric

Examining Cashflow Against SMC Electric'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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".

For the year to June 2022, SMC Electric had an accrual ratio of 0.61. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of HK$2.5m, in contrast to the aforementioned profit of HK$40.4m. We saw that FCF was HK$45m a year ago though, so SMC Electric has at least been able to generate positive FCF in the past. One positive for SMC Electric shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. 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 SMC Electric.

Our Take On SMC Electric's Profit Performance

As we discussed above, we think SMC Electric's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that SMC Electric'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 at least holders can take some solace from the 18% EPS growth 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. If you'd like to know more about SMC Electric as a business, it's important to be aware of any risks it's facing. To help with this, we've discovered 5 warning signs (4 are a bit concerning!) that you ought to be aware of before buying any shares in SMC Electric.

Today we've zoomed in on a single data point to better understand the nature of SMC Electric's profit. 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. 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.