Last week's earnings announcement from Zhongshen Jianye Holding Limited (HKG:2503) was disappointing to investors, with a sluggish profit figure. Our analysis has found some reasons to be concerned, beyond the weak headline numbers.

A Closer Look At Zhongshen Jianye Holding'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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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 June 2024, Zhongshen Jianye Holding recorded an accrual ratio of 0.63. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥21.4m, a look at free cash flow indicates it actually burnt through CN¥125m in the last year. We saw that FCF was CN¥39m a year ago though, so Zhongshen Jianye Holding has at least been able to generate positive FCF in the past.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhongshen Jianye Holding.

Our Take On Zhongshen Jianye Holding's Profit Performance

As we discussed above, we think Zhongshen Jianye Holding's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Zhongshen Jianye Holding's underlying earnings power is lower than its statutory profit. In further bad news, its earnings per share decreased in the last year. 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. If you'd like to know more about Zhongshen Jianye Holding as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 4 warning signs for Zhongshen Jianye Holding you should be mindful of and 1 of them doesn't sit too well with us.

This note has only looked at a single factor that sheds light on the nature of Zhongshen Jianye Holding's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.