Investors were underwhelmed by the solid earnings posted by Convenience Retail Asia Limited (HKG:831) recently. We did some digging and actually think they are being unnecessarily pessimistic.

See our latest analysis for Convenience Retail Asia

Examining Cashflow Against Convenience Retail Asia'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). 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'.

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

Convenience Retail Asia has an accrual ratio of -0.28 for the year to December 2021. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of HK$152m during the period, dwarfing its reported profit of HK$74.4m. Notably, Convenience Retail Asia had negative free cash flow last year, so the HK$152m it produced this year was a welcome improvement. 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 Convenience Retail Asia.

The Impact Of Unusual Items On Profit

While the accrual ratio might bode well, we also note that Convenience Retail Asia's profit was boosted by unusual items worth HK$8.1m 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 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 that's as you'd expect, given these boosts are described as 'unusual'. 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 Convenience Retail Asia's Profit Performance

In conclusion, Convenience Retail Asia's 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 Convenience Retail Asia's profits are a reasonably conservative guide to its underlying 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. For example, Convenience Retail Asia has 4 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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. 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.