Kehua HoldingsLtd's (SHSE:603161) Soft Earnings Are Actually Better Than They Appear

Shareholders appeared unconcerned with Kehua Holdings Co.,Ltd's (SHSE:603161) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

Check out our latest analysis for Kehua HoldingsLtd

A Closer Look At Kehua HoldingsLtd'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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.

For the year to September 2024, Kehua HoldingsLtd had an accrual ratio of -0.27. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥751m during the period, dwarfing its reported profit of CN¥132.8m. Kehua HoldingsLtd 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 Kehua HoldingsLtd.

How Do Unusual Items Influence Profit?

Surprisingly, given Kehua HoldingsLtd's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥23m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. 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 Kehua HoldingsLtd's Profit Performance

Kehua HoldingsLtd's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Considering all the aforementioned, we'd venture that Kehua HoldingsLtd's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. 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. Every company has risks, and we've spotted 2 warning signs for Kehua HoldingsLtd (of which 1 can't be ignored!) 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 are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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 with significant insider holdings 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.