Even though Edensoft Holdings Limited's (HKG:1147) recent earnings release was robust, the market didn't seem to notice. Investors are probably missing some underlying factors which are encouraging for the future of the company.

A Closer Look At Edensoft Holdings' 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.

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. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Edensoft Holdings has an accrual ratio of -1.11 for the year to June 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥147m during the period, dwarfing its reported profit of CN¥7.46m. Given that Edensoft Holdings had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥147m would seem to be a step in the right direction. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio.

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

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Edensoft Holdings profited from a tax benefit which contributed CN¥1.8m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Edensoft Holdings' Profit Performance

In conclusion, Edensoft Holdings has strong cashflow relative to earnings, which indicates good quality earnings, but the tax benefit means its profit wasn't as sustainable as we'd like to see. Based on these factors, it's hard to tell if Edensoft Holdings' profits are a reasonable reflection of its underlying profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For instance, we've identified 2 warning signs for Edensoft Holdings (1 doesn't sit too well with us) you should be familiar with.

Our examination of Edensoft Holdings has focussed on certain factors that can make its earnings look better than they are. 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.