Investors were underwhelmed by the solid earnings posted by Hangzhou Zhongheng Electric Co., Ltd (SZSE:002364) recently. We have done some analysis and have found some comforting factors beneath the profit numbers.

A Closer Look At Hangzhou Zhongheng Electric's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 September 2024, Hangzhou Zhongheng Electric had an accrual ratio of -0.14. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of CN¥389m in the last year, which was a lot more than its statutory profit of CN¥95.0m. Hangzhou Zhongheng Electric shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hangzhou Zhongheng Electric.

The Impact Of Unusual Items On Profit

Hangzhou Zhongheng Electric's profit was reduced by unusual items worth CN¥17m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Hangzhou Zhongheng Electric to produce a higher profit next year, all else being equal.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Hangzhou Zhongheng Electric profited from a tax benefit which contributed CN¥9.3m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! The receipt of a tax benefit is obviously a good thing, on its own. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. 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. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On Hangzhou Zhongheng Electric's Profit Performance

Summing up, Hangzhou Zhongheng Electric's accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect. Based on these factors, we think Hangzhou Zhongheng Electric's earnings potential is at least as good as it seems, and maybe even better! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Be aware that Hangzhou Zhongheng Electric is showing 2 warning signs in our investment analysis and 1 of those is potentially serious...

After our examination into the nature of Hangzhou Zhongheng Electric's profit, we've come away optimistic for the company. 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. 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.