ShenZhen GAD Environmental Technology's (SZSE:300854) Conservative Accounting Might Explain Soft Earnings

ShenZhen GAD Environmental Technology Co., Ltd.'s (SZSE:300854) recent soft profit numbers didn't appear to worry shareholders, as the stock price showed strength. However, we think the company is showing some signs that things are more promising than they seem.

Check out our latest analysis for ShenZhen GAD Environmental Technology

Zooming In On ShenZhen GAD Environmental Technology'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). 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.

For the year to March 2024, ShenZhen GAD Environmental Technology had an accrual ratio of -0.21. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥167m during the period, dwarfing its reported profit of CN¥14.2m. Given that ShenZhen GAD Environmental Technology had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥167m would seem to be a step in the right direction. 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 ShenZhen GAD Environmental Technology.

How Do Unusual Items Influence Profit?

ShenZhen GAD Environmental Technology's profit was reduced by unusual items worth CN¥28m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. 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 that's hardly a surprise given these line items are considered unusual. In the twelve months to March 2024, ShenZhen GAD Environmental Technology had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On ShenZhen GAD Environmental Technology's Profit Performance

In conclusion, both ShenZhen GAD Environmental Technology's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon ShenZhen GAD Environmental Technology's statutory profit probably understates its earnings potential! So while earnings quality is important, it's equally important to consider the risks facing ShenZhen GAD Environmental Technology at this point in time. Be aware that ShenZhen GAD Environmental Technology is showing 4 warning signs in our investment analysis and 2 of those make us uncomfortable...

Our examination of ShenZhen GAD Environmental Technology has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. 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 that insiders are buying 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.