Shareholders appeared unconcerned with Hang Chi Holdings Limited's (HKG:8405) lackluster earnings report last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

Examining Cashflow Against Hang Chi 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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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".

Hang Chi Holdings has an accrual ratio of -0.38 for the year to June 2024. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of HK$77m during the period, dwarfing its reported profit of HK$26.5m. Hang Chi Holdings shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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

Our Take On Hang Chi Holdings' Profit Performance

As we discussed above, Hang Chi Holdings' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Hang Chi Holdings' statutory profit actually understates its earnings potential! Unfortunately, though, its earnings per share actually fell back over 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. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. When we did our research, we found 4 warning signs for Hang Chi Holdings (1 is significant!) that we believe deserve your full attention.

This note has only looked at a single factor that sheds light on the nature of Hang Chi 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.