Why Kwong Luen Engineering Holdings' (HKG:1413) Shaky Earnings Are Just The Beginning Of Its Problems

A lackluster earnings announcement from Kwong Luen Engineering Holdings Limited (HKG:1413) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.

Check out 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Kwong Luen Engineering Holdings has an accrual ratio of 0.66 for the year to March 2021. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of HK$31.1m, a look at free cash flow indicates it actually burnt through HK$34m in the last year. We saw that FCF was HK$14m a year ago though, so Kwong Luen Engineering Holdings has at least been able to generate positive FCF in the past. 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 Kwong Luen Engineering Holdings.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Kwong Luen Engineering Holdings saw its profit reduced by unusual items worth HK$13m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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. If Kwong Luen Engineering Holdings doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Kwong Luen Engineering Holdings' Profit Performance

Kwong Luen Engineering Holdings saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Having considered these factors, we don't think Kwong Luen Engineering Holdings' statutory profits give an overly harsh view of the business. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Our analysis shows 4 warning signs for Kwong Luen Engineering Holdings (1 makes us a bit uncomfortable!) and we strongly recommend you look at them before investing.

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 that insiders are buying to be useful.

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This article by Simply Wall St is general in nature. 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.
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