Shareholders appeared unconcerned with Gstarsoft Co., Ltd.'s (SHSE:688657) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

A Closer Look At Gstarsoft's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 December 2023, Gstarsoft recorded an accrual ratio of -0.28. 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¥66m, well over the CN¥54.1m it reported in profit. Gstarsoft'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 Gstarsoft.

Our Take On Gstarsoft's Profit Performance

Happily for shareholders, Gstarsoft produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Gstarsoft's statutory profit actually understates its earnings potential! And it's also good to see that its earnings per share have improved a bit over the last three years. 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. Just as investors must consider earnings, it is also important to take into account the strength of a company's balance sheet. You can see our latest analysis on Gstarsoft's balance sheet health here.

This note has only looked at a single factor that sheds light on the nature of Gstarsoft's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.