Despite posting some strong earnings, the market for Vodatel Networks Holdings Limited's (HKG:8033) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

A Closer Look At Vodatel Networks 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

Vodatel Networks Holdings has an accrual ratio of 0.41 for the year to June 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of HK$17.9m, a look at free cash flow indicates it actually burnt through HK$55m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of HK$55m, this year, indicates high risk. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

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

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Vodatel Networks Holdings saw its profit reduced by unusual items worth HK$5.9m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. If Vodatel Networks Holdings doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Vodatel Networks Holdings received a tax benefit of HK$1.5m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. We're sure the company was pleased with its tax benefit. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. 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.

Our Take On Vodatel Networks Holdings' Profit Performance

In conclusion, Vodatel Networks Holdings' accrual ratio suggests that its statutory earnings are not backed by cash flow, in part due to the tax benefit it received; but the fact unusual items actually weighed on profit may create upside if those unusual items do not recur. After taking into account all the aforementioned observations we think that Vodatel Networks Holdings' profits probably give a generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To that end, you should learn about the 3 warning signs we've spotted with Vodatel Networks Holdings (including 1 which is a bit concerning).

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.