Legendary Group's (HKG:8195) Soft Earnings Are Actually Better Than They Appear

Investors were disappointed with the weak earnings posted by Legendary Group Limited (HKG:8195 ). Despite the soft profit numbers, our analysis has optimistic about the overall quality of the income statement.

View our latest analysis for Legendary Group

Examining Cashflow Against Legendary Group's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. 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 September 2022, Legendary Group recorded an accrual ratio of -0.10. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of HK$52m, well over the HK$30.0m it reported in profit. Notably, Legendary Group had negative free cash flow last year, so the HK$52m it produced this year was a welcome improvement. However, that's not all there is to consider. 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 Legendary Group.

The Impact Of Unusual Items On Profit

Legendary Group's profit was reduced by unusual items worth HK$3.8m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. 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, after all, that's exactly what the accounting terminology implies. If Legendary Group 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 Legendary Group's Profit Performance

Considering both Legendary Group's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Legendary Group's earnings potential is at least as good as it seems, and maybe even better! If you want to do dive deeper into Legendary Group, you'd also look into what risks it is currently facing. For example - Legendary Group has 2 warning signs we think you should be aware of.

After our examination into the nature of Legendary Group's profit, we've come away optimistic for the company. 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. 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.