Shenzhen Huijie Group's (SZSE:002763) Strong Earnings Are Of Good Quality

The subdued stock price reaction suggests that Shenzhen Huijie Group Co., Ltd.'s (SZSE:002763) strong earnings didn't offer any surprises. We think that investors have missed some encouraging factors underlying the profit figures.

Check out our latest analysis for Shenzhen Huijie Group

A Closer Look At Shenzhen Huijie Group'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. 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to December 2023, Shenzhen Huijie Group recorded an accrual ratio of -0.18. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥382m in the last year, which was a lot more than its statutory profit of CN¥181.9m. Shenzhen Huijie Group's free cash flow improved over the last year, which is generally good to see. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shenzhen Huijie Group.

How Do Unusual Items Influence Profit?

Shenzhen Huijie Group's profit was reduced by unusual items worth CN¥74m 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 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 Shenzhen Huijie Group to produce a higher profit next year, all else being equal.

Our Take On Shenzhen Huijie Group's Profit Performance

In conclusion, both Shenzhen Huijie Group's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Shenzhen Huijie Group's statutory profit probably understates its earnings potential! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 1 warning sign with Shenzhen Huijie Group, and understanding it should be part of your investment process.

Our examination of Shenzhen Huijie Group 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. 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.