Even though Tang Palace (China) Holdings Limited's (HKG:1181) recent earnings release was robust, the market didn't seem to notice. Our analysis suggests that investors might be missing some promising details.

View our latest analysis for Tang Palace (China) Holdings

Examining Cashflow Against Tang Palace (China) Holdings' 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). 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Tang Palace (China) Holdings has an accrual ratio of -1.81 for the year to December 2021. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥136m in the last year, which was a lot more than its statutory profit of CN¥40.6m. Tang Palace (China) Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Tang Palace (China) Holdings.

Our Take On Tang Palace (China) Holdings' Profit Performance

Happily for shareholders, Tang Palace (China) Holdings produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Tang Palace (China) Holdings' statutory profit actually understates its earnings potential! Furthermore, it has done a great job growing EPS over the last year. 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Tang Palace (China) Holdings is showing 3 warning signs in our investment analysis and 1 of those is a bit concerning...

Today we've zoomed in on a single data point to better understand the nature of Tang Palace (China) Holdings' profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 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.