Soft earnings didn't appear to concern Yau Lee Holdings Limited's (HKG:406) shareholders over the last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

View our latest analysis for Yau Lee Holdings

Zooming In On Yau Lee 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. 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".

Yau Lee Holdings has an accrual ratio of -0.32 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$750m in the last year, which was a lot more than its statutory profit of HK$68.2m. Yau Lee Holdings' free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Yau Lee Holdings.

The Impact Of Unusual Items On Profit

Yau Lee Holdings' profit was reduced by unusual items worth HK$41m 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, after all, that's exactly what the accounting terminology implies. If Yau Lee 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 Yau Lee Holdings' Profit Performance

Considering both Yau Lee Holdings' 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 Yau Lee Holdings' statutory profit probably understates its earnings potential! If you'd like to know more about Yau Lee Holdings as a business, it's important to be aware of any risks it's facing. For example, we've discovered 4 warning signs that you should run your eye over to get a better picture of Yau Lee Holdings.

Our examination of Yau Lee 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. 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. 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.