Despite posting some strong earnings, the market for Fountain Set (Holdings) Limited's (HKG:420) stock hasn't moved much. Our analysis suggests that shareholders have noticed something concerning in the numbers.

See our latest analysis for Fountain Set (Holdings)

A Closer Look At Fountain Set (Holdings)'s 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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 2021, Fountain Set (Holdings) had an accrual ratio of 0.21. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of HK$372m despite its profit of HK$241.3m, mentioned above. It's worth noting that Fountain Set (Holdings) generated positive FCF of HK$488m a year ago, so at least they've done it in the past. One positive for Fountain Set (Holdings) 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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

Our Take On Fountain Set (Holdings)'s Profit Performance

Fountain Set (Holdings) didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Fountain Set (Holdings)'s true underlying earnings power is actually less than its statutory profit. The silver lining is that its EPS growth over the last year has been really wonderful, even if it's not a perfect measure. 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. So while earnings quality is important, it's equally important to consider the risks facing Fountain Set (Holdings) at this point in time. To that end, you should learn about the 2 warning signs we've spotted with Fountain Set (Holdings) (including 1 which is a bit concerning).

Today we've zoomed in on a single data point to better understand the nature of Fountain Set (Holdings)'s profit. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.