The market was pleased with the recent earnings report from Monolithic Power Systems, Inc. (NASDAQ:MPWR), despite the profit numbers being soft. However, we think the company is showing some signs that things are more promising than they seem.

Zooming In On Monolithic Power Systems' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to March 2024, Monolithic Power Systems recorded an accrual ratio of -0.23. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of US$603m in the last year, which was a lot more than its statutory profit of US$410.1m. Monolithic Power Systems shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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.

Our Take On Monolithic Power Systems' Profit Performance

As we discussed above, Monolithic Power Systems' 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 Monolithic Power Systems' statutory profit actually understates its earnings potential! And on top of that, its earnings per share have grown at an extremely impressive rate over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you want to do dive deeper into Monolithic Power Systems, you'd also look into what risks it is currently facing. For example, we've discovered 2 warning signs that you should run your eye over to get a better picture of Monolithic Power Systems.

This note has only looked at a single factor that sheds light on the nature of Monolithic Power Systems' 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.