The market was pleased with the recent earnings report from Zhejiang Tengy Environmental Technology Co., Ltd (HKG:1527), despite the profit numbers being soft. However, we think the company is showing some signs that things are more promising than they seem.

A Closer Look At Zhejiang Tengy Environmental Technology's Earnings

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

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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to June 2024, Zhejiang Tengy Environmental Technology had an accrual ratio of -0.41. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥269m in the last year, which was a lot more than its statutory profit of CN¥50.6m. Zhejiang Tengy Environmental Technology 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.

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

How Do Unusual Items Influence Profit?

Surprisingly, given Zhejiang Tengy Environmental Technology's accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥8.8m in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. If Zhejiang Tengy Environmental Technology doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Zhejiang Tengy Environmental Technology's Profit Performance

Zhejiang Tengy Environmental Technology'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 that Zhejiang Tengy Environmental Technology's profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into Zhejiang Tengy Environmental Technology, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 2 warning signs with Zhejiang Tengy Environmental Technology, and understanding these should be part of your investment process.

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 are plenty of other ways to inform your opinion of a company. 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.