VSTECS Holdings Limited's (HKG:856) recent weak earnings report didn't cause a big stock movement. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

See our latest analysis for VSTECS Holdings

Examining Cashflow Against VSTECS Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2022, VSTECS Holdings had an accrual ratio of 0.33. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Over the last year it actually had negative free cash flow of HK$1.8b, in contrast to the aforementioned profit of HK$1.17b. It's worth noting that VSTECS Holdings generated positive FCF of HK$2.7b a year ago, so at least they've done it in the past. The good news for shareholders is that VSTECS 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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 VSTECS Holdings' Profit Performance

As we discussed above, we think VSTECS Holdings' earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that VSTECS Holdings' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Nonetheless, it's still worth noting that its earnings per share have grown at 53% over the last three years. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 3 warning signs for VSTECS Holdings you should be mindful of and 2 of these shouldn't be ignored.

Today we've zoomed in on a single data point to better understand the nature of VSTECS 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. 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.