The market for ECI Technology Holdings Limited's (HKG:8013) stock was strong after it released a healthy earnings report last week. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

See our latest analysis for ECI Technology Holdings

Examining Cashflow Against ECI Technology 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to February 2023, ECI Technology Holdings had an accrual ratio of -0.10. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of HK$13m during the period, dwarfing its reported profit of HK$8.13m. ECI Technology Holdings' free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

Surprisingly, given ECI Technology Holdings' accrual ratio implied strong cash conversion, its paper profit was actually boosted by HK$5.9m in unusual items. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. ECI Technology Holdings had a rather significant contribution from unusual items relative to its profit to February 2023. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On ECI Technology Holdings' Profit Performance

In conclusion, ECI Technology Holdings' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Having considered these factors, we don't think ECI Technology Holdings' statutory profits give an overly harsh view of the business. So while earnings quality is important, it's equally important to consider the risks facing ECI Technology Holdings at this point in time. For example, ECI Technology Holdings has 3 warning signs (and 1 which shouldn'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. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.