Despite posting some strong earnings, the market for Dalian Zhiyun Automation Co., Ltd.'s (SZSE:300097) stock hasn't moved much. Our analysis suggests that shareholders have noticed something concerning in the numbers.

Zooming In On Dalian Zhiyun Automation'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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Dalian Zhiyun Automation has an accrual ratio of 0.29 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. Over the last year it actually had negative free cash flow of CN¥60m, in contrast to the aforementioned profit of CN¥140.0m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥60m, this year, indicates high risk. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio). One positive for Dalian Zhiyun Automation shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Dalian Zhiyun Automation.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Dalian Zhiyun Automation saw its profit reduced by unusual items worth CN¥28m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. In the twelve months to December 2023, Dalian Zhiyun Automation had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Dalian Zhiyun Automation profited from a tax benefit which contributed CN¥11m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. Of course, prima facie it's great to receive a tax benefit. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth.

Our Take On Dalian Zhiyun Automation's Profit Performance

Summing up, Dalian Zhiyun Automation's unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect, and its accrual ratio indicates a lack of free cash flow relative to profit. After taking into account all the aforementioned observations we think that Dalian Zhiyun Automation's profits probably give a generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Dalian Zhiyun Automation at this point in time. For example, we've discovered 2 warning signs that you should run your eye over to get a better picture of Dalian Zhiyun Automation.

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. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.