The recent earnings posted by Guan Chao Holdings Limited (HKG:1872) were solid, but the stock didn't move as much as we expected. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

Check out our latest analysis for Guan Chao Holdings

Zooming In On Guan Chao Holdings' 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. 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 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.

Guan Chao Holdings has an accrual ratio of 0.26 for the year to June 2023. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of S$8.67m, a look at free cash flow indicates it actually burnt through S$18m in the last year. It's worth noting that Guan Chao Holdings generated positive FCF of S$162k a year ago, so at least they've done it in the past. However, that's not all there is to consider. 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 Guan Chao Holdings.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by S$2.8m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. Guan Chao Holdings had a rather significant contribution from unusual items relative to its profit to June 2023. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Guan Chao Holdings' Profit Performance

Guan Chao Holdings had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Guan Chao Holdings' statutory profits might make it look better than it really is on an underlying level. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Our analysis shows 4 warning signs for Guan Chao Holdings (3 are a bit unpleasant!) and we strongly recommend you look at these before investing.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.