Investors signalled that they were pleased with PanAsialum Holdings Company Limited's (HKG:2078) most recent earnings report. This reaction by the market reaction is understandable when looking at headline profits and we have found some further encouraging factors.

A Closer Look At PanAsialum Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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 December 2023, PanAsialum Holdings had an accrual ratio of -0.22. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of HK$219m, well over the HK$27.3m it reported in profit. PanAsialum Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 PanAsialum Holdings.

How Do Unusual Items Influence Profit?

Surprisingly, given PanAsialum Holdings' accrual ratio implied strong cash conversion, its paper profit was actually boosted by HK$9.7m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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, 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 PanAsialum Holdings' Profit Performance

In conclusion, PanAsialum Holdings' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Based on these factors, we think that PanAsialum Holdings' profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into PanAsialum Holdings, you'd also look into what risks it is currently facing. To that end, you should learn about the 3 warning signs we've spotted with PanAsialum Holdings (including 1 which is potentially serious).

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.