The market for Royal Deluxe Holdings Limited's (HKG:3789) shares didn't move much after it posted weak earnings recently. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

A Closer Look At Royal Deluxe 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. 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'.

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 March 2024, Royal Deluxe Holdings recorded an accrual ratio of -0.12. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of HK$35m during the period, dwarfing its reported profit of HK$9.77m. Royal Deluxe Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. 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 Royal Deluxe Holdings.

How Do Unusual Items Influence Profit?

Royal Deluxe Holdings' profit was reduced by unusual items worth HK$3.3m 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. 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. Royal Deluxe Holdings took a rather significant hit from unusual items in the year to March 2024. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Royal Deluxe Holdings' Profit Performance

Considering both Royal Deluxe 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 Royal Deluxe Holdings' earnings potential is at least as good as it seems, and maybe even better! So while earnings quality is important, it's equally important to consider the risks facing Royal Deluxe Holdings at this point in time. When we did our research, we found 4 warning signs for Royal Deluxe Holdings (2 don't sit too well with us!) that we believe deserve your full attention.

After our examination into the nature of Royal Deluxe Holdings' profit, we've come away optimistic for the company. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com