Zhejiang TongLi Transmission Technology's (SZSE:301255) Problems Go Beyond Poor Profit

Zhejiang TongLi Transmission Technology Co., Ltd.'s (SZSE:301255) lackluster earnings announcement last week disappointed investors. We looked deeper and believe that there is even more to be worried about, beyond the soft profit numbers.

See our latest analysis for Zhejiang TongLi Transmission Technology

A Closer Look At Zhejiang TongLi Transmission Technology's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 TongLi Transmission Technology has an accrual ratio of 0.39 for the year to September 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. Over the last year it actually had negative free cash flow of CN¥129m, in contrast to the aforementioned profit of CN¥61.7m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥129m, this year, indicates high risk. Having said that, there is more to the story. 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 TongLi Transmission Technology.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥7.0m, 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. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Zhejiang TongLi Transmission Technology's Profit Performance

Zhejiang TongLi Transmission Technology had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Zhejiang TongLi Transmission Technology'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. Case in point: We've spotted 2 warning signs for Zhejiang TongLi Transmission Technology you should be mindful of and 1 of these bad boys is a bit concerning.

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.