Shareholders didn't appear too concerned by Pan Hong Holdings Group Limited's (SGX:P36) weak earnings. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

View our latest analysis for Pan Hong Holdings Group

Examining Cashflow Against Pan Hong Holdings Group's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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".

For the year to March 2022, Pan Hong Holdings Group had an accrual ratio of 0.81. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥69.3m, a look at free cash flow indicates it actually burnt through CN¥696m in the last year. We saw that FCF was CN¥135m a year ago though, so Pan Hong Holdings Group has at least been able to generate positive FCF in the past. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Pan Hong Holdings Group.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Pan Hong Holdings Group's profit was boosted by unusual items worth CN¥23m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. Pan Hong Holdings Group had a rather significant contribution from unusual items relative to its profit to March 2022. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Pan Hong Holdings Group's Profit Performance

Summing up, Pan Hong Holdings Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Pan Hong Holdings Group's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Pan Hong Holdings Group at this point in time. For instance, we've identified 2 warning signs for Pan Hong Holdings Group (1 is significant) you should be familiar with.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.