Investors Shouldn't Be Too Comfortable With Hong Seng Consolidated Berhad's (KLSE:HONGSENG) Robust Earnings

Hong Seng Consolidated Berhad (KLSE:HONGSENG) announced strong profits, but the stock was stagnant. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

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A Closer Look At Hong Seng Consolidated Berhad's 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Over the twelve months to September 2022, Hong Seng Consolidated Berhad recorded an accrual ratio of 0.96. 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 RM134m, in contrast to the aforementioned profit of RM97.2m. We also note that Hong Seng Consolidated Berhad's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of RM134m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hong Seng Consolidated Berhad.

Our Take On Hong Seng Consolidated Berhad's Profit Performance

As we have made quite clear, we're a bit worried that Hong Seng Consolidated Berhad didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Hong Seng Consolidated Berhad's underlying earnings power is lower than its statutory profit. The good news is that, its earnings per share increased by 49% in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you'd like to know more about Hong Seng Consolidated Berhad as a business, it's important to be aware of any risks it's facing. In terms of investment risks, we've identified 2 warning signs with Hong Seng Consolidated Berhad, and understanding these should be part of your investment process.

Today we've zoomed in on a single data point to better understand the nature of Hong Seng Consolidated Berhad's profit. 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 that insiders are buying.

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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.