The most recent earnings report from UMP Healthcare Holdings Limited (HKG:722) was disappointing for shareholders. Despite the soft profit numbers, our analysis has optimistic about the overall quality of the income statement.

Examining Cashflow Against UMP Healthcare Holdings' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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.

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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

UMP Healthcare Holdings has an accrual ratio of -0.10 for the year to June 2024. Therefore, its statutory earnings were quite a lot less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of HK$92m, well over the HK$40.6m it reported in profit. UMP Healthcare Holdings 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 UMP Healthcare Holdings.

How Do Unusual Items Influence Profit?

UMP Healthcare Holdings' profit was reduced by unusual items worth HK$7.4m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If UMP Healthcare Holdings doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On UMP Healthcare Holdings' Profit Performance

In conclusion, both UMP Healthcare Holdings' accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. 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. So while earnings quality is important, it's equally important to consider the risks facing UMP Healthcare Holdings at this point in time. For instance, we've identified 4 warning signs for UMP Healthcare Holdings (1 shouldn't be ignored) you should be familiar with.

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. 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.