Shareholders appeared unconcerned with UMP Healthcare Holdings Limited's (HKG:722) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.

A Closer Look At UMP Healthcare 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

UMP Healthcare Holdings has an accrual ratio of -0.11 for the year to December 2023. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of HK$81m during the period, dwarfing its reported profit of HK$33.7m. UMP Healthcare Holdings' free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. 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 UMP Healthcare Holdings.

How Do Unusual Items Influence Profit?

UMP Healthcare Holdings' profit was reduced by unusual items worth HK$8.9m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect UMP Healthcare Holdings to produce a higher profit next year, all else being equal.

Our Take On UMP Healthcare Holdings' Profit Performance

Considering both UMP Healthcare Holdings' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that UMP Healthcare Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Case in point: We've spotted 4 warning signs for UMP Healthcare Holdings you should be aware of.

Our examination of UMP Healthcare 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. 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 that insiders are buying 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.