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Even though Nam Cheong Limited (SGX:1MZ) posted strong earnings recently, the stock hasn't reacted in a large way. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.
A Closer Look At Nam Cheong's Earnings
Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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".
For the year to December 2024, Nam Cheong had an accrual ratio of 1.00. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of RM93m during the period, falling well short of its reported profit of RM785.2m. Notably, Nam Cheong had negative free cash flow last year, so the RM93m it produced this year was a welcome improvement. 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.
Check out our latest analysis for Nam Cheong
Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Nam Cheong.
The Impact Of Unusual Items On Profit
Given the accrual ratio, it's not overly surprising that Nam Cheong's profit was boosted by unusual items worth RM441m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. We can see that Nam Cheong's positive unusual items were quite significant relative to its profit in the year to December 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.