There Are Some Reasons To Suggest That Kwung's Aroma Holdings' (HKG:1925) Earnings Are A Poor Reflection Of Profitability

Solid profit numbers didn't seem to be enough to please Kwung's Aroma Holdings Limited's (HKG:1925) shareholders. Our analysis suggests they may be concerned about some underlying details.

See our latest analysis for Kwung's Aroma Holdings

Examining Cashflow Against Kwung's Aroma 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.

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. 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.

Over the twelve months to June 2024, Kwung's Aroma Holdings recorded an accrual ratio of 0.20. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In fact, it had free cash flow of CN¥25m in the last year, which was a lot less than its statutory profit of CN¥81.1m. We note, however, that Kwung's Aroma Holdings grew its free cash flow over the last year. Having said that, there is more to the story. 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 Kwung's Aroma Holdings.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Kwung's Aroma Holdings' profit was boosted by unusual items worth CN¥28m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. Kwung's Aroma Holdings had a rather significant contribution from unusual items relative to its profit to June 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Kwung's Aroma Holdings' Profit Performance

Summing up, Kwung's Aroma Holdings received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Kwung's Aroma Holdings' profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Kwung's Aroma Holdings as a business, it's important to be aware of any risks it's facing. Our analysis shows 3 warning signs for Kwung's Aroma Holdings (1 is concerning!) and we strongly recommend you look at these before investing.

Our examination of Kwung's Aroma Holdings has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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 with high insider ownership.

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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.