Fameglow Holdings Limited (HKG:8603) announced strong profits, but the stock was stagnant. We did some digging, and we found some concerning factors in the details.

Examining Cashflow Against Fameglow 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. 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. 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".

Over the twelve months to September 2024, Fameglow Holdings recorded an accrual ratio of 1.00. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of HK$23m, which is significantly less than its profit of HK$55.7m. Fameglow Holdings' free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits.

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

Our Take On Fameglow Holdings' Profit Performance

As we have made quite clear, we're a bit worried that Fameglow Holdings didn't back up the last year's profit with free cashflow. As a result, we think it may well be the case that Fameglow Holdings' underlying earnings power is lower than its statutory profit. The silver lining is that its EPS growth over the last year has been really wonderful, even if it's not a perfect measure. 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. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, we've found that Fameglow Holdings has 2 warning signs (1 can't be ignored!) that deserve your attention before going any further with your analysis.

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