When companies post strong earnings, the stock generally performs well, just like Luen Thai Holdings Limited's (HKG:311) stock has recently. Our analysis found some more factors that we think are good for shareholders.

See our latest analysis for Luen Thai Holdings

A Closer Look At Luen Thai Holdings' 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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2021, Luen Thai Holdings recorded an accrual ratio of -0.17. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of US$47m, well over the US$11.2m it reported in profit. Given that Luen Thai Holdings had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$47m would seem to be a step in the right direction. 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 Luen Thai Holdings.

The Impact Of Unusual Items On Profit

Surprisingly, given Luen Thai Holdings' accrual ratio implied strong cash conversion, its paper profit was actually boosted by US$2.0m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. If Luen Thai Holdings 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 Luen Thai Holdings' Profit Performance

In conclusion, Luen Thai Holdings' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Considering all the aforementioned, we'd venture that Luen Thai Holdings' profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For instance, we've identified 3 warning signs for Luen Thai Holdings (1 is significant) you should be familiar with.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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. 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.