Kato (Hong Kong) Holdings' (HKG:2189) Anemic Earnings Might Be Worse Than You Think

The subdued market reaction suggests that Kato (Hong Kong) Holdings Limited's (HKG:2189) recent earnings didn't contain any surprises. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

See our latest analysis for Kato (Hong Kong) Holdings

Zooming In On Kato (Hong Kong) 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. 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. 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".

For the year to September 2024, Kato (Hong Kong) Holdings had an accrual ratio of -0.11. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of HK$128m during the period, dwarfing its reported profit of HK$69.9m. Kato (Hong Kong) Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 Kato (Hong Kong) Holdings.

How Do Unusual Items Influence Profit?

Surprisingly, given Kato (Hong Kong) Holdings' accrual ratio implied strong cash conversion, its paper profit was actually boosted by HK$22m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. We can see that Kato (Hong Kong) Holdings' positive unusual items were quite significant relative to its profit in the year to September 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 Kato (Hong Kong) Holdings' Profit Performance

Kato (Hong Kong) Holdings' profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Having considered these factors, we don't think Kato (Hong Kong) Holdings' statutory profits give an overly harsh view of the business. If you want to do dive deeper into Kato (Hong Kong) Holdings, you'd also look into what risks it is currently facing. You'd be interested to know, that we found 2 warning signs for Kato (Hong Kong) Holdings and you'll want to know about these.

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 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 with high insider ownership.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.