We Think That There Are Some Issues For Kantone Holdings (HKG:1059) Beyond Its Promising Earnings

Kantone Holdings Limited's (HKG:1059) robust recent earnings didn't do much to move the stock. However the statutory profit number doesn't tell the whole story, and we have found some factors which might be of concern to shareholders.

Check out our latest analysis for Kantone Holdings

A Closer Look At Kantone Holdings' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to December 2024, Kantone Holdings had an accrual ratio of 0.41. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of HK$8.8m, in contrast to the aforementioned profit of HK$11.7m. We saw that FCF was HK$32m a year ago though, so Kantone Holdings has at least been able to generate positive FCF in the past. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively. The good news for shareholders is that Kantone Holdings' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Kantone Holdings issued 20% more new shares over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Kantone Holdings' historical EPS growth by clicking on this link.

A Look At The Impact Of Kantone Holdings' Dilution On Its Earnings Per Share (EPS)

As you can see above, Kantone Holdings has been growing its net income over the last few years, with an annualized gain of 445% over three years. In comparison, earnings per share only gained 310% over the same period. And in the last year the company managed to bump profit up by 4.5%. But that's starkly different from the 5.7% drop in earnings per share. So you can see that the dilution has had a bit of an impact on shareholders.

If Kantone Holdings' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

Kantone Holdings' profit suffered from unusual items, which reduced profit by HK$894k in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. 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 Kantone Holdings 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 Kantone Holdings' Profit Performance

In conclusion, Kantone Holdings' accrual ratio suggests that its statutory earnings are not backed by cash flow; but the fact unusual items actually weighed on profit may create upside if those unusual items to not recur. On top of that, the dilution means that shareholders now own less of the company. For the reasons mentioned above, we think that a perfunctory glance at Kantone Holdings' statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Our analysis shows 4 warning signs for Kantone Holdings (2 shouldn't be ignored!) and we strongly recommend you look at these bad boys before investing.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.