Investors were disappointed by Zhejiang Zoenn Design Co., Ltd.'s (SZSE:300901 ) latest earnings release. Our analysis has found some reasons to be concerned, beyond the weak headline numbers.

A Closer Look At Zhejiang Zoenn Design'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Zhejiang Zoenn Design has an accrual ratio of 0.33 for the year to December 2023. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥163m despite its profit of CN¥21.3m, mentioned above. We also note that Zhejiang Zoenn Design's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥163m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang Zoenn Design.

Our Take On Zhejiang Zoenn Design's Profit Performance

As we have made quite clear, we're a bit worried that Zhejiang Zoenn Design didn't back up the last year's profit with free cashflow. For this reason, we think that Zhejiang Zoenn Design's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. Sadly, its EPS was down over the last twelve months. 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. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 5 warning signs for Zhejiang Zoenn Design (of which 3 are potentially serious!) you should know about.

This note has only looked at a single factor that sheds light on the nature of Zhejiang Zoenn Design's profit. 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. 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.