Soft earnings didn't appear to concern Theme International Holdings Limited's (HKG:990) shareholders over the last week. We did some digging, and we believe the earnings are stronger than they seem.

A Closer Look At Theme International 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. 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".

For the year to June 2024, Theme International Holdings had an accrual ratio of -3.63. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of HK$4.2b in the last year, which was a lot more than its statutory profit of HK$665.3m. Theme International Holdings' free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Theme International Holdings' profit was boosted by unusual items worth HK$116m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. If Theme International Holdings doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Theme International Holdings' Profit Performance

Theme International Holdings' profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Considering all the aforementioned, we'd venture that Theme International Holdings' profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. In terms of investment risks, we've identified 2 warning signs with Theme International Holdings, and understanding them should be part of your investment process.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.