Shenzhen Zhongheng Huafa's (SZSE:000020) Solid Earnings Have Been Accounted For Conservatively

Shareholders appeared to be happy with Shenzhen Zhongheng Huafa Co., Ltd.'s (SZSE:000020) solid earnings report last week. Looking deeper at the numbers, we found several encouraging factors beyond the headline profit numbers.

View our latest analysis for Shenzhen Zhongheng Huafa

Examining Cashflow Against Shenzhen Zhongheng Huafa'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Shenzhen Zhongheng Huafa has an accrual ratio of -0.24 for the year to March 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of CN¥80m in the last year, which was a lot more than its statutory profit of CN¥12.3m. Shenzhen Zhongheng Huafa shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 Zhongheng Huafa.

The Impact Of Unusual Items On Profit

Shenzhen Zhongheng Huafa's profit was reduced by unusual items worth CN¥5.1m 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. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. If Shenzhen Zhongheng Huafa doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Shenzhen Zhongheng Huafa's Profit Performance

In conclusion, both Shenzhen Zhongheng Huafa's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon Shenzhen Zhongheng Huafa's statutory profit probably understates its earnings potential! In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. In terms of investment risks, we've identified 2 warning signs with Shenzhen Zhongheng Huafa, and understanding them should be part of your investment process.

After our examination into the nature of Shenzhen Zhongheng Huafa's profit, we've come away optimistic for the company. 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.