The subdued stock price reaction suggests that Pou Sheng International (Holdings) Limited's (HKG:3813) strong earnings didn't offer any surprises. We think that investors have missed some encouraging factors underlying the profit figures.

Examining Cashflow Against Pou Sheng International (Holdings)'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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 December 2023, Pou Sheng International (Holdings) recorded an accrual ratio of -0.43. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of CN¥3.1b, well over the CN¥490.4m it reported in profit. Pou Sheng International (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. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

The Impact Of Unusual Items On Profit

Pou Sheng International (Holdings)'s profit was reduced by unusual items worth CN¥82m 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If Pou Sheng International (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 Pou Sheng International (Holdings)'s Profit Performance

Considering both Pou Sheng International (Holdings)'s accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. After considering all this, we reckon Pou Sheng International (Holdings)'s statutory profit probably understates its earnings potential! So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Pou Sheng International (Holdings).

After our examination into the nature of Pou Sheng International (Holdings)'s profit, we've come away optimistic for the company. 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.