The market shrugged off the recent earnings report from Hung Fook Tong Group Holdings Limited (HKG:1446), despite the profit numbers being soft. However, we think the company is showing some signs that things are more promising than they seem.

See our latest analysis for Hung Fook Tong Group Holdings

Examining Cashflow Against Hung Fook Tong Group 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Hung Fook Tong Group Holdings has an accrual ratio of -0.40 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. To wit, it produced free cash flow of HK$107m during the period, dwarfing its reported profit of HK$8.22m. Hung Fook Tong Group Holdings did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. 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 Hung Fook Tong Group Holdings.

The Impact Of Unusual Items On Profit

While the accrual ratio might bode well, we also note that Hung Fook Tong Group Holdings' profit was boosted by unusual items worth HK$2.1m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Hung Fook Tong Group Holdings' Profit Performance

Hung Fook Tong Group Holdings' profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think that Hung Fook Tong Group 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 Hung Fook Tong Group Holdings at this point in time. For example, we've discovered 3 warning signs that you should run your eye over to get a better picture of Hung Fook Tong Group Holdings.

Our examination of Hung Fook Tong Group Holdings has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.