Despite announcing strong earnings, Guizhou Zhenhua Fengguang Semiconductor Co., Ltd.'s (SHSE:688439) stock was sluggish. We did some digging and found some worrying underlying problems.

Zooming In On Guizhou Zhenhua Fengguang Semiconductor's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 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 June 2024, Guizhou Zhenhua Fengguang Semiconductor had an accrual ratio of 0.43. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥585.3m, a look at free cash flow indicates it actually burnt through CN¥499m in the last year. We also note that Guizhou Zhenhua Fengguang Semiconductor's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥499m.

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 Guizhou Zhenhua Fengguang Semiconductor's Profit Performance

As we have made quite clear, we're a bit worried that Guizhou Zhenhua Fengguang Semiconductor didn't back up the last year's profit with free cashflow. For this reason, we think that Guizhou Zhenhua Fengguang Semiconductor'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 the good news is that its EPS growth over the last three years has been very impressive. 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 Guizhou Zhenhua Fengguang Semiconductor at this point in time. For example, we've found that Guizhou Zhenhua Fengguang Semiconductor has 2 warning signs (1 is significant!) that deserve your attention before going any further with your analysis.

Today we've zoomed in on a single data point to better understand the nature of Guizhou Zhenhua Fengguang Semiconductor's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 with significant insider holdings 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.