Strong Petrochemical Holdings Limited's (HKG:852) solid earnings announcement recently didn't do much to the stock price. Our analysis suggests that shareholders might be missing some positive underlying factors in the earnings report.

View our latest analysis for Strong Petrochemical Holdings

Zooming In On Strong Petrochemical Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.

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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to June 2022, Strong Petrochemical Holdings had an accrual ratio of -0.20. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of HK$283m in the last year, which was a lot more than its statutory profit of HK$25.3m. Strong Petrochemical Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Strong Petrochemical Holdings' profit was boosted by unusual items worth HK$9.7m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. If Strong Petrochemical Holdings doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Strong Petrochemical Holdings' Profit Performance

In conclusion, Strong Petrochemical Holdings' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Based on these factors, we think that Strong Petrochemical Holdings' profits are a reasonably conservative guide to its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing Strong Petrochemical Holdings at this point in time. Every company has risks, and we've spotted 3 warning signs for Strong Petrochemical Holdings (of which 1 is significant!) you should know about.

Our examination of Strong Petrochemical Holdings has focussed on certain factors that can make its earnings look better than they are. 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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.