Even though King Stone Energy Group Limited (HKG:663) posted strong earnings recently, the stock hasn't reacted in a large way. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

Check out our latest analysis for King Stone Energy Group

A Closer Look At King Stone Energy Group's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to June 2023, King Stone Energy Group recorded an accrual ratio of 0.26. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of HK$90.8m, a look at free cash flow indicates it actually burnt through HK$10m in the last year. We also note that King Stone Energy Group's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of HK$10m. 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 King Stone Energy Group.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by HK$347m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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 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. King Stone Energy Group had a rather significant contribution from unusual items relative to its profit to June 2023. 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 King Stone Energy Group's Profit Performance

Summing up, King Stone Energy Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue King Stone Energy Group's profits probably give an overly generous impression of its sustainable level of profitability. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. To that end, you should learn about the 2 warning signs we've spotted with King Stone Energy Group (including 1 which doesn't sit too well with us).

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.