Zhongfu Shenying Carbon FiberLtd's (SHSE:688295) Earnings Quality Is Low

Zhongfu Shenying Carbon Fiber Co.,Ltd.'s (SHSE:688295) weak earnings were disregarded by the market. Despite the market responding positively, we think that there are several concerning factors that investors should be aware of.

See our latest analysis for Zhongfu Shenying Carbon FiberLtd

A Closer Look At Zhongfu Shenying Carbon FiberLtd'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. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to December 2023, Zhongfu Shenying Carbon FiberLtd had an accrual ratio of 0.30. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Over the last year it actually had negative free cash flow of CN¥947m, in contrast to the aforementioned profit of CN¥318.0m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥947m, this year, indicates high risk. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zhongfu Shenying Carbon FiberLtd's profit was boosted by unusual items worth CN¥83m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. We can see that Zhongfu Shenying Carbon FiberLtd's positive unusual items were quite significant relative to its profit in the year to December 2023. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Zhongfu Shenying Carbon FiberLtd's Profit Performance

Summing up, Zhongfu Shenying Carbon FiberLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at Zhongfu Shenying Carbon FiberLtd's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Zhongfu Shenying Carbon FiberLtd as a business, it's important to be aware of any risks it's facing. To that end, you should learn about the 2 warning signs we've spotted with Zhongfu Shenying Carbon FiberLtd (including 1 which shouldn't be ignored).

Our examination of Zhongfu Shenying Carbon FiberLtd has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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.