Perennial International's (HKG:725) Soft Earnings Are Actually Better Than They Appear

Soft earnings didn't appear to concern Perennial International Limited's (HKG:725) shareholders over the last week. We did some digging, and we believe the earnings are stronger than they seem.

View our latest analysis for Perennial International

A Closer Look At Perennial International's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Perennial International recorded an accrual ratio of -0.10. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of HK$54m in the last year, which was a lot more than its statutory profit of HK$15.7m. Perennial International did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. 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 Perennial International.

How Do Unusual Items Influence Profit?

Perennial International's profit was reduced by unusual items worth HK$11m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Perennial International took a rather significant hit from unusual items in the year to December 2023. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Perennial International's Profit Performance

In conclusion, both Perennial International's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Looking at all these factors, we'd say that Perennial International's underlying earnings power is at least as good as the statutory numbers would make it seem. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example - Perennial International has 2 warning signs we think you should be aware of.

Our examination of Perennial International 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. 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.