Shareholders appeared to be happy with Vtech Holdings Limited's (HKG:303) solid earnings report last week. According to our analysis of the report, the strong headline profit numbers are supported by strong earnings fundamentals.

Zooming In On Vtech 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. 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. 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 March 2024, Vtech Holdings recorded an accrual ratio of -0.41. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of US$323m in the last year, which was a lot more than its statutory profit of US$166.6m. Vtech Holdings' free cash flow improved over the last year, which is generally good to see.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Vtech Holdings' Profit Performance

Happily for shareholders, Vtech Holdings produced plenty of free cash flow to back up its statutory profit numbers. Based on this observation, we consider it possible that Vtech Holdings' statutory profit actually understates its earnings potential! And the EPS is up 12% over the last twelve months. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Our analysis shows 2 warning signs for Vtech Holdings (1 is potentially serious!) and we strongly recommend you look at them before investing.

This note has only looked at a single factor that sheds light on the nature of Vtech Holdings' 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. 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.