Wanda Hotel Development Company Limited (HKG:169) just reported healthy earnings but the stock price didn't move much. We think that investors have missed some encouraging factors underlying the profit figures.

See our latest analysis for Wanda Hotel Development

A Closer Look At Wanda Hotel Development's 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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to December 2021, Wanda Hotel Development recorded an accrual ratio of -0.19. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of HK$513m during the period, dwarfing its reported profit of HK$240.5m. Notably, Wanda Hotel Development had negative free cash flow last year, so the HK$513m it produced this year was a welcome improvement. Having said that, there is more to the story. 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 Wanda Hotel Development.

The Impact Of Unusual Items On Profit

Wanda Hotel Development's profit was reduced by unusual items worth HK$53m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. 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, after all, that's exactly what the accounting terminology implies. If Wanda Hotel Development 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 Wanda Hotel Development's Profit Performance

Considering both Wanda Hotel Development's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon Wanda Hotel Development's statutory profit probably understates its earnings potential! While earnings are important, another area to consider is the balance sheet. You can see our latest analysis on Wanda Hotel Development's balance sheet health here.

After our examination into the nature of Wanda Hotel Development's profit, we've come away optimistic for the company. 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. 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.