The market for Hygieia Group Limited's (HKG:1650) shares didn't move much after it posted weak earnings recently. We did some digging, and we believe the earnings are stronger than they seem.

See our latest analysis for Hygieia Group

A Closer Look At Hygieia Group's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. The ratio shows us how much a company's profit exceeds its FCF.

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".

For the year to June 2022, Hygieia Group had an accrual ratio of -0.29. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of S$6.0m during the period, dwarfing its reported profit of S$2.09m. Hygieia Group did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. Having said that, there is more to the story. 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 Hygieia Group.

How Do Unusual Items Influence Profit?

Surprisingly, given Hygieia Group's accrual ratio implied strong cash conversion, its paper profit was actually boosted by S$875k in unusual items. 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. Hygieia Group had a rather significant contribution from unusual items relative to its profit to June 2022. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Hygieia Group's Profit Performance

In conclusion, Hygieia Group's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Given the contrasting considerations, we don't have a strong view as to whether Hygieia Group's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing Hygieia Group at this point in time. Our analysis shows 5 warning signs for Hygieia Group (1 can't be ignored!) and we strongly recommend you look at these before investing.

Our examination of Hygieia Group 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. 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.