The subdued stock price reaction suggests that Shanghai Zhenhua Heavy Industries Co., Ltd.'s (SHSE:600320) strong earnings didn't offer any surprises. Investors are probably missing some underlying factors which are encouraging for the future of the company.

A Closer Look At Shanghai Zhenhua Heavy Industries' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. 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 March 2024, Shanghai Zhenhua Heavy Industries had an accrual ratio of -0.11. That indicates that its free cash flow was a fair bit more than its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥5.5b, well over the CN¥560.3m it reported in profit. Shanghai Zhenhua Heavy Industries shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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.

How Do Unusual Items Influence Profit?

Surprisingly, given Shanghai Zhenhua Heavy Industries' accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥113m 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. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Shanghai Zhenhua Heavy Industries' Profit Performance

Shanghai Zhenhua Heavy Industries' 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, it's hard to tell if Shanghai Zhenhua Heavy Industries' profits are a reasonable reflection of its underlying profitability. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. To help with this, we've discovered 2 warning signs (1 makes us a bit uncomfortable!) that you ought to be aware of before buying any shares in Shanghai Zhenhua Heavy Industries.

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 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.