The subdued stock price reaction suggests that New Century Healthcare Holding Co. Limited's (HKG:1518) strong earnings didn't offer any surprises. Our analysis suggests that investors might be missing some promising details.

Examining Cashflow Against New Century Healthcare Holding's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

New Century Healthcare Holding has an accrual ratio of -0.51 for the year to June 2024. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥164m, well over the CN¥86.3m it reported in profit. New Century Healthcare Holding 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 New Century Healthcare Holding.

How Do Unusual Items Influence Profit?

New Century Healthcare Holding's profit was reduced by unusual items worth CN¥24m 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 New Century Healthcare Holding to produce a higher profit next year, all else being equal.

Our Take On New Century Healthcare Holding's Profit Performance

Considering both New Century Healthcare Holding's 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 New Century Healthcare Holding's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! If you'd like to know more about New Century Healthcare Holding as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 2 warning signs for New Century Healthcare Holding you should know about.

Our examination of New Century Healthcare Holding has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. 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 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.