We Think Shenzhen Zhongheng Huafa's (SZSE:000020) Healthy Earnings Might Be Conservative

Shareholders appeared to be happy with Shenzhen Zhongheng Huafa Co., Ltd.'s (SZSE:000020) solid earnings report last week. This reaction by the market reaction is understandable when looking at headline profits and we have found some further encouraging factors.

See our latest analysis for Shenzhen Zhongheng Huafa

Zooming In On Shenzhen Zhongheng Huafa'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to September 2024, Shenzhen Zhongheng Huafa had an accrual ratio of -0.33. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of CN¥110m, well over the CN¥15.1m it reported in profit. Notably, Shenzhen Zhongheng Huafa had negative free cash flow last year, so the CN¥110m it produced this year was a welcome improvement. 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.

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¥3.6m 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. 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 Shenzhen Zhongheng Huafa to produce a higher profit next year, all else being equal.

Our Take On Shenzhen Zhongheng Huafa's Profit Performance

Considering both Shenzhen Zhongheng Huafa's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Shenzhen Zhongheng Huafa's underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example - Shenzhen Zhongheng Huafa has 1 warning sign we think you should be aware of.

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

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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.