There May Be Underlying Issues With The Quality Of Kwong Luen Engineering Holdings' (HKG:1413) Earnings

Despite announcing strong earnings, Kwong Luen Engineering Holdings Limited's (HKG:1413) stock was sluggish. We did some digging and found some worrying underlying problems.

View our latest analysis for Kwong Luen Engineering Holdings

Examining Cashflow Against Kwong Luen Engineering Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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.

Over the twelve months to March 2024, Kwong Luen Engineering Holdings recorded an accrual ratio of 0.22. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of HK$17.3m, a look at free cash flow indicates it actually burnt through HK$38m in the last year. We also note that Kwong Luen Engineering Holdings' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of HK$38m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Kwong Luen Engineering Holdings.

Our Take On Kwong Luen Engineering Holdings' Profit Performance

Kwong Luen Engineering Holdings' accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that Kwong Luen Engineering Holdings' true underlying earnings power is actually less than its statutory profit. But the happy news is that, while acknowledging we have to look beyond the statutory numbers, those numbers are still improving, with EPS growing at a very high rate over the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. 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. When we did our research, we found 3 warning signs for Kwong Luen Engineering Holdings (2 are a bit concerning!) that we believe deserve your full attention.

Today we've zoomed in on a single data point to better understand the nature of Kwong Luen Engineering Holdings' profit. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com