Despite posting some strong earnings, the market for MEGAIN Holding (Cayman) Co., Ltd.'s (HKG:6939) stock hasn't moved much. We did some digging, and we found some concerning factors in the details.

View our latest analysis for MEGAIN Holding (Cayman)

Zooming In On MEGAIN Holding (Cayman)'s Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to June 2022, MEGAIN Holding (Cayman) recorded an accrual ratio of 0.41. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of CN¥11m in the last year, which was a lot less than its statutory profit of CN¥43.8m. MEGAIN Holding (Cayman)'s 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of MEGAIN Holding (Cayman).

Our Take On MEGAIN Holding (Cayman)'s Profit Performance

As we have made quite clear, we're a bit worried that MEGAIN Holding (Cayman) didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that MEGAIN Holding (Cayman)'s underlying earnings power is lower than its statutory profit. The good news is that, its earnings per share increased by 61% 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 while earnings quality is important, it's equally important to consider the risks facing MEGAIN Holding (Cayman) at this point in time. For example, we've found that MEGAIN Holding (Cayman) has 5 warning signs (2 are significant!) that deserve your attention before going any further with your analysis.

Today we've zoomed in on a single data point to better understand the nature of MEGAIN Holding (Cayman)'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.