Shareholders didn't appear too concerned by Zhenhai Petrochemical Engineering CO., LTD's (SHSE:603637) weak earnings. Our analysis suggests that they may be missing some concerning details underlying the profit numbers.

A Closer Look At Zhenhai Petrochemical Engineering'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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to June 2024, Zhenhai Petrochemical Engineering recorded an accrual ratio of 1.89. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥94.8m, a look at free cash flow indicates it actually burnt through CN¥75m in the last year. It's worth noting that Zhenhai Petrochemical Engineering generated positive FCF of CN¥116m a year ago, so at least they've done it in the past. 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. The good news for shareholders is that Zhenhai Petrochemical Engineering's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhenhai Petrochemical Engineering.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Zhenhai Petrochemical Engineering's profit was boosted by unusual items worth CN¥6.2m 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 that's as you'd expect, given these boosts are described as 'unusual'. 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 Zhenhai Petrochemical Engineering's Profit Performance

Summing up, Zhenhai Petrochemical Engineering received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Zhenhai Petrochemical Engineering's profits probably give an overly generous impression of its sustainable level of profitability. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Be aware that Zhenhai Petrochemical Engineering is showing 2 warning signs in our investment analysis and 1 of those shouldn't be ignored...

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.