Dynamic Holdings Limited (HKG:29) announced strong profits, but the stock was stagnant. Our analysis suggests that shareholders have noticed something concerning in the numbers.

Examining Cashflow Against Dynamic 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. 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. 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. 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. 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, Dynamic Holdings recorded an accrual ratio of 1.17. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of HK$7.2m in the last year, which was a lot less than its statutory profit of HK$5.37b. At this point we should mention that Dynamic Holdings did manage to increase its free cash flow in the last twelve months The good news for shareholders is that Dynamic Holdings' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

Our Take On Dynamic Holdings' Profit Performance

As we have made quite clear, we're a bit worried that Dynamic Holdings didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Dynamic Holdings' underlying earnings power is lower than its statutory profit. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Case in point: We've spotted 1 warning sign for Dynamic Holdings you should be aware of.

Today we've zoomed in on a single data point to better understand the nature of Dynamic Holdings' profit. But there are plenty of other ways to inform your opinion of a company. 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.