The subdued stock price reaction suggests that L&K Engineering (Suzhou) Co.,Ltd.'s (SHSE:603929) strong earnings didn't offer any surprises. Our analysis suggests that investors might be missing some promising details.

A Closer Look At L&K Engineering (Suzhou)Ltd's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the 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 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".

L&K Engineering (Suzhou)Ltd has an accrual ratio of -0.50 for the year to December 2023. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of CN¥521m, well over the CN¥286.9m it reported in profit. L&K Engineering (Suzhou)Ltd's free cash flow improved over the last year, which is generally good to see.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of L&K Engineering (Suzhou)Ltd.

Our Take On L&K Engineering (Suzhou)Ltd's Profit Performance

As we discussed above, L&K Engineering (Suzhou)Ltd's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that L&K Engineering (Suzhou)Ltd's statutory profit actually understates its earnings potential! Furthermore, it has done a great job growing EPS 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 while earnings quality is important, it's equally important to consider the risks facing L&K Engineering (Suzhou)Ltd at this point in time. You'd be interested to know, that we found 1 warning sign for L&K Engineering (Suzhou)Ltd and you'll want to know about this.

This note has only looked at a single factor that sheds light on the nature of L&K Engineering (Suzhou)Ltd'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.