Investors were underwhelmed by the solid earnings posted by Karrie International Holdings Limited (HKG:1050) recently. We did some digging and actually think they are being unnecessarily pessimistic.

View our latest analysis for Karrie International Holdings

Zooming In On Karrie International 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. The ratio shows us how much a company's profit exceeds its FCF.

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.

Over the twelve months to September 2023, Karrie International Holdings recorded an accrual ratio of -0.14. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of HK$401m, well over the HK$163.2m it reported in profit. Karrie International Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. 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 Karrie International Holdings.

How Do Unusual Items Influence Profit?

Karrie International Holdings' profit was reduced by unusual items worth HK$34m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Karrie International 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 Karrie International Holdings' Profit Performance

Considering both Karrie International Holdings' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Karrie International Holdings' earnings potential is at least as good as it seems, and maybe even better! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Be aware that Karrie International Holdings is showing 3 warning signs in our investment analysis and 1 of those is potentially serious...

Our examination of Karrie International Holdings has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.