The market for Pentamaster International Limited's (HKG:1665) stock was strong after it released a healthy earnings report last week. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

Check out our latest analysis for Pentamaster International

Examining Cashflow Against Pentamaster International'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Pentamaster International has an accrual ratio of 0.33 for the year to June 2022. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. To wit, it produced free cash flow of RM26m during the period, falling well short of its reported profit of RM125.3m. Pentamaster International's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits.

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 Pentamaster International's Profit Performance

As we discussed above, we think Pentamaster International's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Pentamaster International's underlying earnings power is lower than its statutory profit. Nonetheless, it's still worth noting that its earnings per share have grown at 7.4% over the last three years. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. In terms of investment risks, we've identified 1 warning sign with Pentamaster International, and understanding it should be part of your investment process.

This note has only looked at a single factor that sheds light on the nature of Pentamaster International's 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.