Additional Considerations Required While Assessing Success Dragon International Holdings' (HKG:1182) Strong Earnings

Last week's profit announcement from Success Dragon International Holdings Limited (HKG:1182) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

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A Closer Look At Success Dragon International 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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Success Dragon International Holdings has an accrual ratio of 0.94 for the year to September 2025. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of HK$46m despite its profit of HK$37.6m, mentioned above. We also note that Success Dragon International Holdings' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of HK$46m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Success Dragon International Holdings.

Our Take On Success Dragon International Holdings' Profit Performance

As we have made quite clear, we're a bit worried that Success Dragon International Holdings didn't back up the last year's profit with free cashflow. For this reason, we think that Success Dragon International Holdings' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The silver lining is that its EPS growth over the last year has been really wonderful, even if it's not a perfect measure. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing Success Dragon International Holdings at this point in time. Our analysis shows 3 warning signs for Success Dragon International Holdings (2 are a bit unpleasant!) and we strongly recommend you look at them before investing.

Today we've zoomed in on a single data point to better understand the nature of Success Dragon International Holdings' profit. But there are plenty of other ways to inform your opinion of a company. Some people consider a high return on equity to be a good sign of a quality business. 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.