The market was pleased with the recent earnings report from Shenzhen Tagen Group Co., Ltd. (SZSE:000090), despite the profit numbers being soft. However, we think the company is showing some signs that things are more promising than they seem.

Examining Cashflow Against Shenzhen Tagen Group'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. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2024, Shenzhen Tagen Group recorded an accrual ratio of -0.15. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥4.3b in the last year, which was a lot more than its statutory profit of CN¥818.7m. Shenzhen Tagen Group did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the 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

While the accrual ratio might bode well, we also note that Shenzhen Tagen Group's profit was boosted by unusual items worth CN¥97m 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 Shenzhen Tagen Group 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 Shenzhen Tagen Group's Profit Performance

In conclusion, Shenzhen Tagen Group's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Based on these factors, we think that Shenzhen Tagen Group's profits are a reasonably conservative guide to its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing Shenzhen Tagen Group at this point in time. At Simply Wall St, we found 1 warning sign for Shenzhen Tagen Group and we think they deserve your attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.