The recent earnings posted by E-Commodities Holdings Limited (HKG:1733) were solid, but the stock didn't move as much as we expected. We believe that shareholders have noticed some concerning factors beyond the statutory profit numbers.

Zooming In On E-Commodities Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.

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. 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 June 2024, E-Commodities Holdings recorded an accrual ratio of 0.37. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of HK$2.06b, a look at free cash flow indicates it actually burnt through HK$197m in the last year. We saw that FCF was HK$2.5b a year ago though, so E-Commodities Holdings has at least been able to generate positive FCF in the past. The good news for shareholders is that E-Commodities Holdings' accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

Our Take On E-Commodities Holdings' Profit Performance

As we have made quite clear, we're a bit worried that E-Commodities Holdings didn't back up the last year's profit with free cashflow. For this reason, we think that E-Commodities Holdings' statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you want to do dive deeper into E-Commodities Holdings, you'd also look into what risks it is currently facing. Be aware that E-Commodities Holdings is showing 3 warning signs in our investment analysis and 1 of those is a bit unpleasant...

This note has only looked at a single factor that sheds light on the nature of E-Commodities Holdings' profit. 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.