The market seemed underwhelmed by last week's earnings announcement from Kingmaker Footwear Holdings Limited (HKG:1170) despite the healthy numbers. We did some digging, and we think that investors are missing some encouraging factors in the underlying numbers.

View our latest analysis for Kingmaker Footwear Holdings

Zooming In On Kingmaker Footwear 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. The ratio shows us how much a company's profit exceeds its FCF.

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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Kingmaker Footwear Holdings has an accrual ratio of -0.13 for the year to September 2023. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of HK$154m during the period, dwarfing its reported profit of HK$46.5m. Given that Kingmaker Footwear Holdings had negative free cash flow in the prior corresponding period, the trailing twelve month resul of HK$154m would seem to be a step in the right direction. 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 Kingmaker Footwear Holdings.

How Do Unusual Items Influence Profit?

Kingmaker Footwear Holdings' profit was reduced by unusual items worth HK$13m 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. 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 Kingmaker Footwear Holdings to produce a higher profit next year, all else being equal.

Our Take On Kingmaker Footwear Holdings' Profit Performance

Considering both Kingmaker Footwear Holdings' 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 Kingmaker Footwear Holdings' earnings potential is at least as good as it seems, and maybe even better! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 2 warning signs for Kingmaker Footwear Holdings you should know about.

Our examination of Kingmaker Footwear 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 are plenty of other ways to inform your opinion of a company. 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 that insiders are buying.

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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.