Justin Allen Holdings Limited (HKG:1425) just reported some strong earnings, and the market rewarded them with a positive share price move. We did some analysis and think that investors are missing some details hidden beneath the profit numbers.

See our latest analysis for Justin Allen Holdings

Zooming In On Justin Allen 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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Justin Allen Holdings has an accrual ratio of 0.26 for the year to December 2021. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. To wit, it produced free cash flow of HK$76m during the period, falling well short of its reported profit of HK$158.3m. Justin Allen Holdings' free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. One positive for Justin Allen 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 Justin Allen Holdings.

Our Take On Justin Allen Holdings' Profit Performance

Justin Allen Holdings' accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Justin Allen Holdings' statutory profits are better than its underlying earnings power. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Justin Allen Holdings at this point in time. For example, Justin Allen Holdings has 4 warning signs (and 1 which is potentially serious) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of Justin Allen Holdings' 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. 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.

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.