We Think Hangzhou Zhongheng Electric's (SZSE:002364) Profit Is Only A Baseline For What They Can Achieve

Hangzhou Zhongheng Electric Co., Ltd's (SZSE:002364) earnings announcement last week was disappointing for investors, despite the decent profit numbers. We did some digging and actually think they are being unnecessarily pessimistic.

See our latest analysis for Hangzhou Zhongheng Electric

Examining Cashflow Against Hangzhou Zhongheng Electric'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). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2024, Hangzhou Zhongheng Electric had an accrual ratio of -0.14. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of CN¥389m during the period, dwarfing its reported profit of CN¥95.0m. Hangzhou Zhongheng Electric shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio).

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Hangzhou Zhongheng Electric.

How Do Unusual Items Influence Profit?

Hangzhou Zhongheng Electric's profit was reduced by unusual items worth CN¥17m 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. 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 that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Hangzhou Zhongheng Electric to produce a higher profit next year, all else being equal.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Hangzhou Zhongheng Electric received a tax benefit of CN¥9.3m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Hangzhou Zhongheng Electric's Profit Performance

Summing up, Hangzhou Zhongheng Electric's accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect. Based on these factors, we think Hangzhou Zhongheng Electric's earnings potential is at least as good as it seems, and maybe even better! If you want to do dive deeper into Hangzhou Zhongheng Electric, you'd also look into what risks it is currently facing. Our analysis shows 2 warning signs for Hangzhou Zhongheng Electric (1 is significant!) and we strongly recommend you look at these before investing.

After our examination into the nature of Hangzhou Zhongheng Electric'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. 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.