Shareholders Can Be Confident That E Lighting Group Holdings' (HKG:8222) Earnings Are High Quality

E Lighting Group Holdings Limited (HKG:8222) just reported healthy earnings but the stock price didn't move much. We think that investors have missed some encouraging factors underlying the profit figures.

View our latest analysis for E Lighting Group Holdings

Examining Cashflow Against E Lighting Group 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'.

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.

E Lighting Group Holdings has an accrual ratio of -2.61 for the year to March 2021. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of HK$22m, well over the HK$8.16m it reported in profit. E Lighting Group Holdings' free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. 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 E Lighting Group Holdings.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that E Lighting Group Holdings' profit was boosted by unusual items worth HK$1.8m in the last twelve months. 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. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On E Lighting Group Holdings' Profit Performance

E Lighting Group 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. Based on these factors, we think that E Lighting Group Holdings' profits are a reasonably conservative guide to its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing E Lighting Group Holdings at this point in time. Our analysis shows 3 warning signs for E Lighting Group Holdings (1 can't be ignored!) and we strongly recommend you look at them before investing.

Our examination of E Lighting Group Holdings has focussed on certain factors that can make its earnings look better than they are. 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. 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. 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.
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