Shareholders appeared unconcerned with Fairwood Holdings Limited's (HKG:52) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.

See our latest analysis for Fairwood Holdings

Examining Cashflow Against Fairwood 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2022, Fairwood Holdings had an accrual ratio of -2.99. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of HK$485m in the last year, which was a lot more than its statutory profit of HK$42.6m. Fairwood Holdings' free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. 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 Fairwood Holdings.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Fairwood Holdings' profit was boosted by unusual items worth HK$9.4m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Fairwood Holdings' Profit Performance

In conclusion, Fairwood 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 Fairwood Holdings' profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. When we did our research, we found 4 warning signs for Fairwood Holdings (1 is potentially serious!) that we believe deserve your full attention.

Our examination of Fairwood Holdings has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.