Investors were disappointed with Playmates Toys Limited's (HKG:869) recent earnings release. Our analysis found several concerning factors in the earnings report beyond the strong statutory profit number.

Examining Cashflow Against Playmates Toys' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. 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 December 2023, Playmates Toys had an accrual ratio of 2.97. 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. To wit, it produced free cash flow of HK$86m during the period, falling well short of its reported profit of HK$223.7m. We note, however, that Playmates Toys grew its free cash flow over the last year. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for Playmates Toys shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. 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 Playmates Toys.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Playmates Toys' profit was boosted by unusual items worth HK$18m 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. 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, after all, that's exactly what the accounting terminology implies. If Playmates Toys 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 Playmates Toys' Profit Performance

Playmates Toys had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Playmates Toys' profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Playmates Toys, you'd also look into what risks it is currently facing. For instance, we've identified 3 warning signs for Playmates Toys (1 is concerning) you should be familiar with.

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 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.

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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.