Investors Can Find Comfort In Shenzhen HeungKong HoldingLtd's (SHSE:600162) Earnings Quality

Shenzhen HeungKong Holding Co.,Ltd's (SHSE:600162) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

Check out our latest analysis for Shenzhen HeungKong HoldingLtd

Zooming In On Shenzhen HeungKong HoldingLtd'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. 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. 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, Shenzhen HeungKong HoldingLtd had an accrual ratio of -0.11. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥1.0b, well over the CN¥69.5m it reported in profit. Shenzhen HeungKong HoldingLtd's free cash flow improved over the last year, which is generally good to see. 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 Shenzhen HeungKong HoldingLtd.

The Impact Of Unusual Items On Profit

Shenzhen HeungKong HoldingLtd's profit was reduced by unusual items worth CN¥87m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Shenzhen HeungKong HoldingLtd to produce a higher profit next year, all else being equal.

Our Take On Shenzhen HeungKong HoldingLtd's Profit Performance

In conclusion, both Shenzhen HeungKong HoldingLtd's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Shenzhen HeungKong HoldingLtd's earnings potential is at least as good as it seems, and maybe even better! If you'd like to know more about Shenzhen HeungKong HoldingLtd as a business, it's important to be aware of any risks it's facing. Be aware that Shenzhen HeungKong HoldingLtd is showing 3 warning signs in our investment analysis and 1 of those is potentially serious...

Our examination of Shenzhen HeungKong HoldingLtd has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. 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.