Statutory Profit Doesn't Reflect How Good Edensoft Holdings' (HKG:1147) Earnings Are

Edensoft Holdings Limited (HKG:1147) just reported healthy earnings but the stock price didn't move much. Investors are probably missing some underlying factors which are encouraging for the future of the company.

View our latest analysis for Edensoft Holdings

A Closer Look At Edensoft Holdings' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to June 2024, Edensoft Holdings recorded an accrual ratio of -1.11. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥147m in the last year, which was a lot more than its statutory profit of CN¥7.46m. Notably, Edensoft Holdings had negative free cash flow last year, so the CN¥147m it produced this year was a welcome improvement. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation.

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

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Edensoft Holdings profited from a tax benefit which contributed CN¥1.8m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! Of course, prima facie it's great to receive a tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On Edensoft Holdings' Profit Performance

While Edensoft Holdings' accrual ratio stands testament to its strong cashflow, and indicates good quality earnings, the fact that it received a tax benefit suggests that this year's profit may not be a great guide to its sustainable profit run-rate. Given the contrasting considerations, we don't have a strong view as to whether Edensoft Holdings's profits are an apt reflection of its underlying potential for profit. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, Edensoft Holdings has 2 warning signs (and 1 which can't be ignored) we think you should know about.

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.

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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.