Why Kwung's Aroma Holdings' (HKG:1925) Earnings Are Weaker Than They Seem

Despite posting strong earnings, Kwung's Aroma Holdings Limited's (HKG:1925) stock didn't move much over the last week. We think that investors might be worried about the foundations the earnings are built on.

Our free stock report includes 4 warning signs investors should be aware of before investing in Kwung's Aroma Holdings. Read for free now.

A Closer Look At 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. 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 2024, Kwung's Aroma Holdings recorded an accrual ratio of 0.55. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥118.6m, a look at free cash flow indicates it actually burnt through CN¥66m in the last year. We also note that Kwung's Aroma Holdings' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥66m. 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.

View our latest analysis for Kwung's Aroma Holdings

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?

The fact that the company had unusual items boosting profit by CN¥27m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. Kwung's Aroma Holdings had a rather significant contribution from unusual items relative to its profit to December 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. For the reasons mentioned above, we think that a perfunctory glance at Kwung's Aroma Holdings' statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Kwung's Aroma Holdings at this point in time. Our analysis shows 4 warning signs for Kwung's Aroma Holdings (1 is significant!) 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 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.