Shanghai Zhongchen Electronic Technology Co.,Ltd. (SHSE:603275) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. We did some analysis and think that investors are missing some details hidden beneath the profit numbers.

A Closer Look At Shanghai Zhongchen Electronic TechnologyLtd'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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to June 2024, Shanghai Zhongchen Electronic TechnologyLtd recorded an accrual ratio of 0.34. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥37m despite its profit of CN¥204.2m, mentioned above. It's worth noting that Shanghai Zhongchen Electronic TechnologyLtd generated positive FCF of CN¥135m a year ago, so at least they've done it in the past. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shanghai Zhongchen Electronic TechnologyLtd.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Shanghai Zhongchen Electronic TechnologyLtd's profit was boosted by unusual items worth CN¥18m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If Shanghai Zhongchen Electronic TechnologyLtd doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Shanghai Zhongchen Electronic TechnologyLtd's Profit Performance

Summing up, Shanghai Zhongchen Electronic TechnologyLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Shanghai Zhongchen Electronic TechnologyLtd's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Shanghai Zhongchen Electronic TechnologyLtd, you'd also look into what risks it is currently facing. For example - Shanghai Zhongchen Electronic TechnologyLtd has 1 warning sign we think you should be aware of.

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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.