Shareholders appeared unconcerned with China MeiDong Auto Holdings Limited's (HKG:1268) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

View our latest analysis for China MeiDong Auto Holdings

A Closer Look At China MeiDong Auto Holdings' 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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".

China MeiDong Auto Holdings has an accrual ratio of -0.12 for the year to June 2024. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of CN¥761m during the period, dwarfing its reported profit of CN¥74.2m. China MeiDong Auto Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

China MeiDong Auto Holdings' profit was reduced by unusual items worth CN¥153m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect China MeiDong Auto Holdings to produce a higher profit next year, all else being equal.

Our Take On China MeiDong Auto Holdings' Profit Performance

Considering both China MeiDong Auto Holdings' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that China MeiDong Auto Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. If you want to do dive deeper into China MeiDong Auto Holdings, you'd also look into what risks it is currently facing. Case in point: We've spotted 2 warning signs for China MeiDong Auto Holdings you should be aware of.

After our examination into the nature of China MeiDong Auto Holdings' profit, we've come away optimistic for the company. 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 with significant insider holdings to be useful.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.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.