The market seemed underwhelmed by last week's earnings announcement from Smart City Development Holdings Limited (HKG:8268) despite the healthy numbers. We did some digging, and we think that investors are missing some encouraging factors in the underlying numbers.

See our latest analysis for Smart City Development Holdings

Examining Cashflow Against Smart City Development 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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Smart City Development Holdings has an accrual ratio of -0.77 for the year to March 2022. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of HK$42m in the last year, which was a lot more than its statutory profit of HK$15.3m. Notably, Smart City Development Holdings had negative free cash flow last year, so the HK$42m 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 Smart City Development Holdings.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Smart City Development Holdings' profit was boosted by unusual items worth HK$2.1m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. 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 that's as you'd expect, given these boosts are described as 'unusual'. If Smart City Development 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 Smart City Development Holdings' Profit Performance

In conclusion, Smart City Development 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 Smart City Development Holdings' profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. If you want to do dive deeper into Smart City Development Holdings, you'd also look into what risks it is currently facing. For instance, we've identified 2 warning signs for Smart City Development Holdings (1 is a bit concerning) you should be familiar with.

Our examination of Smart City Development Holdings has focussed on certain factors that can make its earnings look better than they are. 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.