Last week's earnings announcement from ZJMI Environmental Energy Co., Ltd. (SHSE:603071) was disappointing to investors, with a sluggish profit figure. We did some analysis, and found that there are some reasons to be cautious about the headline numbers.

Examining Cashflow Against ZJMI Environmental Energy's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

ZJMI Environmental Energy has an accrual ratio of 0.36 for the year to March 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥1.2b despite its profit of CN¥990.1m, mentioned above. We saw that FCF was CN¥2.5b a year ago though, so ZJMI Environmental Energy has at least been able to generate positive FCF in the past. The good news for shareholders is that ZJMI Environmental Energy'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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On ZJMI Environmental Energy's Profit Performance

As we discussed above, we think ZJMI Environmental Energy's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that ZJMI Environmental Energy's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But at least holders can take some solace from the 30% per annum growth in EPS for the last three. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. So while earnings quality is important, it's equally important to consider the risks facing ZJMI Environmental Energy at this point in time. To that end, you should learn about the 2 warning signs we've spotted with ZJMI Environmental Energy (including 1 which is potentially serious).

This note has only looked at a single factor that sheds light on the nature of ZJMI Environmental Energy'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.