Shenzhen Zhongheng Huafa Co., Ltd.'s (SZSE:200020) recent weak earnings report didn't cause a big stock movement. However, we believe that investors should be aware of some underlying factors which may be of concern.

View our latest analysis for Shenzhen Zhongheng Huafa

A Closer Look At Shenzhen Zhongheng Huafa'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. 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. 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. 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 June 2022, Shenzhen Zhongheng Huafa recorded an accrual ratio of -0.11. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of CN¥53m during the period, dwarfing its reported profit of CN¥9.02m. Shenzhen Zhongheng Huafa's free cash flow improved over the last year, which is generally good to see. 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 Shenzhen Zhongheng Huafa.

The Impact Of Unusual Items On Profit

Surprisingly, given Shenzhen Zhongheng Huafa's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥5.9m in unusual items. 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. We can see that Shenzhen Zhongheng Huafa's positive unusual items were quite significant relative to its profit in the year to June 2022. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Shenzhen Zhongheng Huafa's Profit Performance

Shenzhen Zhongheng Huafa's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think it's very unlikely that Shenzhen Zhongheng Huafa's statutory profits make it seem much weaker than it is. So while earnings quality is important, it's equally important to consider the risks facing Shenzhen Zhongheng Huafa at this point in time. For example - Shenzhen Zhongheng Huafa has 1 warning sign we think you should be aware of.

Our examination of Shenzhen Zhongheng Huafa has focussed on certain factors that can make its earnings look better than they are. 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 that insiders are buying.

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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.