The market shrugged off Shenzhen Highpower Technology Co., Ltd.'s (SZSE:001283) weak earnings report last week. We looked at the details, and we think that investors may be responding to some encouraging factors.

A Closer Look At Shenzhen Highpower Technology'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.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to March 2024, Shenzhen Highpower Technology had an accrual ratio of 0.53. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥52.0m, a look at free cash flow indicates it actually burnt through CN¥1.3b in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥1.3b, this year, indicates high risk. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

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.

The Impact Of Unusual Items On Profit

Shenzhen Highpower Technology's profit suffered from unusual items, which reduced profit by CN¥71m in the last twelve months. 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Shenzhen Highpower Technology took a rather significant hit from unusual items in the year to March 2024. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Shenzhen Highpower Technology profited from a tax benefit which contributed CN¥30m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. We're sure the company was pleased with its tax benefit. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Shenzhen Highpower Technology's Profit Performance

In conclusion, Shenzhen Highpower Technology's accrual ratio suggests that its statutory earnings are not backed by cash flow, in part due to the tax benefit it received; but the fact unusual items actually weighed on profit may create upside if those unusual items do not recur. After taking into account all the aforementioned observations we think that Shenzhen Highpower Technology's profits probably give a generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For instance, we've identified 4 warning signs for Shenzhen Highpower Technology (1 is significant) you should be familiar with.

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.