Keystone Electrical (Zhejiang)Ltd's (SZSE:301448) Conservative Accounting Might Explain Soft Earnings

Soft earnings didn't appear to concern Keystone Electrical (Zhejiang) Co.,Ltd.'s (SZSE:301448) shareholders over the last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

Check out our latest analysis for Keystone Electrical (Zhejiang)Ltd

Examining Cashflow Against Keystone Electrical (Zhejiang)Ltd's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Keystone Electrical (Zhejiang)Ltd recorded an accrual ratio of -0.20. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥82m during the period, dwarfing its reported profit of CN¥51.4m. Keystone Electrical (Zhejiang)Ltd did see its free cash flow drop year on year, which is less than ideal, like a Simpson's episode without Groundskeeper Willie. 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 Keystone Electrical (Zhejiang)Ltd.

The Impact Of Unusual Items On Profit

Keystone Electrical (Zhejiang)Ltd's profit was reduced by unusual items worth CN¥13m 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Keystone Electrical (Zhejiang)Ltd to produce a higher profit next year, all else being equal.

Our Take On Keystone Electrical (Zhejiang)Ltd's Profit Performance

In conclusion, both Keystone Electrical (Zhejiang)Ltd's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Keystone Electrical (Zhejiang)Ltd's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! So while earnings quality is important, it's equally important to consider the risks facing Keystone Electrical (Zhejiang)Ltd at this point in time. You'd be interested to know, that we found 2 warning signs for Keystone Electrical (Zhejiang)Ltd and you'll want to know about them.

Our examination of Keystone Electrical (Zhejiang)Ltd 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. 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 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.