Shenzhen Zhilai Sci and Tech's (SZSE:300771) Sluggish Earnings Might Be Just The Beginning Of Its Problems

A lackluster earnings announcement from Shenzhen Zhilai Sci and Tech Co., Ltd. (SZSE:300771) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

See our latest analysis for Shenzhen Zhilai Sci and Tech

Examining Cashflow Against Shenzhen Zhilai Sci and Tech'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.

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

Shenzhen Zhilai Sci and Tech has an accrual ratio of -0.13 for the year to December 2023. That indicates that its free cash flow was a fair bit more than its statutory profit. To wit, it produced free cash flow of CN¥93m during the period, dwarfing its reported profit of CN¥24.5m. Shenzhen Zhilai Sci and Tech 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. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shenzhen Zhilai Sci and Tech.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Shenzhen Zhilai Sci and Tech's profit was boosted by unusual items worth CN¥10m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. Shenzhen Zhilai Sci and Tech had a rather significant contribution from unusual items relative to its profit 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 Shenzhen Zhilai Sci and Tech's Profit Performance

In conclusion, Shenzhen Zhilai Sci and Tech's accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Having considered these factors, we don't think Shenzhen Zhilai Sci and Tech's statutory profits give an overly harsh view of the business. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, Shenzhen Zhilai Sci and Tech has 5 warning signs (and 2 which are a bit concerning) we think you should know about.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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. 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.