Investors Can Find Comfort In Tengda Construction Group's (SHSE:600512) Earnings Quality

Soft earnings didn't appear to concern Tengda Construction Group Co., Ltd.'s (SHSE:600512) shareholders over the last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

See our latest analysis for Tengda Construction Group

Examining Cashflow Against Tengda Construction Group's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to September 2024, Tengda Construction Group had an accrual ratio of 0.29. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥56.1m, a look at free cash flow indicates it actually burnt through CN¥942m in the last year. We saw that FCF was CN¥184m a year ago though, so Tengda Construction Group has at least been able to generate positive FCF in the past. However, that's not all there is to consider. 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 Tengda Construction Group.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Tengda Construction Group saw its profit reduced by unusual items worth CN¥32m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Tengda Construction Group took a rather significant hit from unusual items in the year to September 2024. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Tengda Construction Group's Profit Performance

Tengda Construction Group saw unusual items weigh on its profit, which should have made it easier to show high cash conversion, which it did not do, according to its accrual ratio. Considering all the aforementioned, we'd venture that Tengda Construction Group's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. So while earnings quality is important, it's equally important to consider the risks facing Tengda Construction Group at this point in time. To help with this, we've discovered 4 warning signs (2 are concerning!) that you ought to be aware of before buying any shares in Tengda Construction Group.

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 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.