The subdued market reaction suggests that Zhong Ao Home Group Limited's (HKG:1538) recent earnings didn't contain any surprises. We think that investors are worried about some weaknesses underlying the earnings.

See our latest analysis for Zhong Ao Home Group

A Closer Look At Zhong Ao Home Group's 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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".

For the year to December 2021, Zhong Ao Home Group had an accrual ratio of 0.24. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥106.3m, a look at free cash flow indicates it actually burnt through CN¥17m in the last year. It's worth noting that Zhong Ao Home Group generated positive FCF of CN¥194m a year ago, so at least they've done it in the past. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Zhong Ao Home Group's 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 Zhong Ao Home Group.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Zhong Ao Home Group's profit was boosted by unusual items worth CN¥19m 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. If Zhong Ao Home Group 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 Zhong Ao Home Group's Profit Performance

Summing up, Zhong Ao Home Group received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Zhong Ao Home Group's profits probably give an overly generous impression of its sustainable level of profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Be aware that Zhong Ao Home Group is showing 4 warning signs in our investment analysis and 1 of those 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 that insiders are buying 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.