Shaky Earnings May Not Tell The Whole Story For Zhenhai Petrochemical Engineering (SHSE:603637)

Zhenhai Petrochemical Engineering CO., LTD's (SHSE:603637) stock wasn't much affected by its recent lackluster earnings numbers. Our analysis suggests that they may be missing some concerning details underlying the profit numbers.

See our latest analysis for Zhenhai Petrochemical Engineering

Zooming In On Zhenhai Petrochemical Engineering's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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 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. 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, Zhenhai Petrochemical Engineering had an accrual ratio of 1.89. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of CN¥75m, in contrast to the aforementioned profit of CN¥94.8m. 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. 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. 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.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥18m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. Zhenhai Petrochemical Engineering had a rather significant contribution from unusual items relative to its profit to June 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Zhenhai Petrochemical Engineering's Profit Performance

Zhenhai Petrochemical Engineering had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Zhenhai Petrochemical Engineering's profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, Zhenhai Petrochemical Engineering has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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

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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.