Zhuhai Enpower ElectricLtd's (SZSE:300681) Profits Appear To Have Quality Issues

Zhuhai Enpower Electric Co.,Ltd.'s (SZSE:300681) healthy profit numbers didn't contain any surprises for investors. We think this is due to investors looking beyond the statutory profits and being concerned with what they see.

See our latest analysis for Zhuhai Enpower ElectricLtd

Zooming In On Zhuhai Enpower ElectricLtd'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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.

Zhuhai Enpower ElectricLtd has an accrual ratio of 0.32 for the year to December 2023. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥82.4m, a look at free cash flow indicates it actually burnt through CN¥445m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥445m, this year, indicates high risk. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhuhai Enpower ElectricLtd.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Zhuhai Enpower ElectricLtd saw its profit reduced by unusual items worth CN¥30m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Zhuhai Enpower ElectricLtd to produce a higher profit next year, all else being equal.

Our Take On Zhuhai Enpower ElectricLtd's Profit Performance

In conclusion, Zhuhai Enpower ElectricLtd's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Having considered these factors, we don't think Zhuhai Enpower ElectricLtd's statutory profits give an overly harsh view of the business. So while earnings quality is important, it's equally important to consider the risks facing Zhuhai Enpower ElectricLtd at this point in time. Our analysis shows 2 warning signs for Zhuhai Enpower ElectricLtd (1 makes us a bit uncomfortable!) and we strongly recommend you look at them before investing.

Our examination of Zhuhai Enpower ElectricLtd 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.