Following the solid earnings report from Zhejiang Xinchai Co.,Ltd (SZSE:301032), the market responded by bidding up the stock price. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

Zooming In On Zhejiang XinchaiLtd'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). 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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

For the year to September 2024, Zhejiang XinchaiLtd had an accrual ratio of 0.27. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥95m despite its profit of CN¥74.2m, mentioned above. We also note that Zhejiang XinchaiLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥95m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang XinchaiLtd.

Our Take On Zhejiang XinchaiLtd's Profit Performance

Zhejiang XinchaiLtd's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Therefore, it seems possible to us that Zhejiang XinchaiLtd's true underlying earnings power is actually less than its statutory profit. The silver lining is that its EPS growth over the last year has been really wonderful, even if it's not a perfect measure. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Zhejiang XinchaiLtd at this point in time. Every company has risks, and we've spotted 3 warning signs for Zhejiang XinchaiLtd you should know about.

Today we've zoomed in on a single data point to better understand the nature of Zhejiang XinchaiLtd'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. 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.