The market wasn't impressed with the soft earnings from Zhejiang Zhengguang Industrial Co., Ltd. (SZSE:301092) recently. We did some further digging and think they have a few more reasons to be concerned beyond the statutory profit.

Zooming In On Zhejiang Zhengguang Industrial'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. 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.

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. 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 March 2024, Zhejiang Zhengguang Industrial had an accrual ratio of 0.47. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥143m despite its profit of CN¥114.3m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥143m, this year, indicates high risk.

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

Our Take On Zhejiang Zhengguang Industrial's Profit Performance

As we discussed above, we think Zhejiang Zhengguang Industrial's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Zhejiang Zhengguang Industrial's underlying earnings power is lower than its statutory profit. Sadly, its EPS was down over the last twelve months. 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. If you want to do dive deeper into Zhejiang Zhengguang Industrial, you'd also look into what risks it is currently facing. You'd be interested to know, that we found 2 warning signs for Zhejiang Zhengguang Industrial and you'll want to know about these.

Today we've zoomed in on a single data point to better understand the nature of Zhejiang Zhengguang Industrial's profit. 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.