Shareholders Can Be Confident That Zhejiang Tengen ElectricsLtd's (SHSE:605066) Earnings Are High Quality

Zhejiang Tengen Electrics Co.,Ltd. (SHSE:605066) just reported healthy earnings but the stock price didn't move much. Investors are probably missing some underlying factors which are encouraging for the future of the company.

View our latest analysis for Zhejiang Tengen ElectricsLtd

Zooming In On Zhejiang Tengen ElectricsLtd'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 March 2024, Zhejiang Tengen ElectricsLtd had an accrual ratio of -0.16. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥303m in the last year, which was a lot more than its statutory profit of CN¥136.4m. Zhejiang Tengen ElectricsLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. 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 Tengen ElectricsLtd.

The Impact Of Unusual Items On Profit

Zhejiang Tengen ElectricsLtd's profit was reduced by unusual items worth CN¥25m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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 Zhejiang Tengen ElectricsLtd to produce a higher profit next year, all else being equal.

Our Take On Zhejiang Tengen ElectricsLtd's Profit Performance

Considering both Zhejiang Tengen ElectricsLtd's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Looking at all these factors, we'd say that Zhejiang Tengen ElectricsLtd's underlying earnings power is at least as good as the statutory numbers would make it seem. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Every company has risks, and we've spotted 2 warning signs for Zhejiang Tengen ElectricsLtd (of which 1 shouldn't be ignored!) you should know about.

After our examination into the nature of Zhejiang Tengen ElectricsLtd's profit, we've come away optimistic for the company. 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 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.