The market seemed underwhelmed by last week's earnings announcement from Daphne International Holdings Limited (HKG:210) despite the healthy numbers. Our analysis suggests that shareholders might be missing some positive underlying factors in the earnings report.

Check out our latest analysis for Daphne International Holdings

Zooming In On Daphne International 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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, Daphne International Holdings had an accrual ratio of -0.11. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of HK$85m during the period, dwarfing its reported profit of HK$27.1m. Notably, Daphne International Holdings had negative free cash flow last year, so the HK$85m it produced this year was a welcome improvement. 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 Daphne International Holdings.

How Do Unusual Items Influence Profit?

Daphne International Holdings' profit was reduced by unusual items worth HK$12m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Daphne International Holdings doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Daphne International Holdings' Profit Performance

In conclusion, both Daphne International Holdings' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Looking at all these factors, we'd say that Daphne International Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. While conducting our analysis, we found that Daphne International Holdings has 2 warning signs and it would be unwise to ignore these.

Our examination of Daphne International Holdings has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. 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.