There May Be Underlying Issues With The Quality Of Zhejiang XinchaiLtd's (SZSE:301032) Earnings

Zhejiang Xinchai Co.,Ltd's (SZSE:301032) stock was strong after they recently reported robust earnings. We did some analysis and think that investors are missing some details hidden beneath the profit numbers.

See our latest analysis for Zhejiang XinchaiLtd

Zooming In On Zhejiang XinchaiLtd'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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Zhejiang XinchaiLtd has an accrual ratio of 0.43 for the year to March 2024. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥186m despite its profit of CN¥43.1m, mentioned above. It's worth noting that Zhejiang XinchaiLtd generated positive FCF of CN¥284m a year ago, so at least they've done it in the past. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio. One positive for Zhejiang XinchaiLtd shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang XinchaiLtd.

The Impact Of Unusual Items On Profit

Zhejiang XinchaiLtd's profit suffered from unusual items, which reduced profit by CN¥7.5m in the last twelve months. 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 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 Zhejiang XinchaiLtd to produce a higher profit next year, all else being equal.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Zhejiang XinchaiLtd profited from a tax benefit which contributed CN¥3.1m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. Of course, prima facie it's great to receive a tax benefit. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Zhejiang XinchaiLtd's Profit Performance

Summing up, Zhejiang XinchaiLtd's unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect, and its accrual ratio indicates a lack of free cash flow relative to profit. After taking into account all the aforementioned observations we think that Zhejiang XinchaiLtd's profits probably give a 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. Be aware that Zhejiang XinchaiLtd is showing 3 warning signs in our investment analysis and 2 of those are potentially serious...

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. 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.