Zhejiang Tengy Environmental Technology's (HKG:1527) Soft Earnings Don't Show The Whole Picture

Shareholders appeared unconcerned with Zhejiang Tengy Environmental Technology Co., Ltd's (HKG:1527) lackluster earnings report last week. Our analysis suggests that while the profits are soft, the foundations of the business are strong.

Check out our latest analysis for Zhejiang Tengy Environmental Technology

Zooming In On Zhejiang Tengy Environmental Technology'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. The ratio shows us how much a company's profit exceeds its FCF.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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.

Zhejiang Tengy Environmental Technology has an accrual ratio of -0.29 for the year to December 2023. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of CN¥212m, well over the CN¥42.7m it reported in profit. Zhejiang Tengy Environmental Technology shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 Zhejiang Tengy Environmental Technology.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Zhejiang Tengy Environmental Technology's profit was boosted by unusual items worth CN¥9.6m 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. And that's as you'd expect, given these boosts are described as 'unusual'. If Zhejiang Tengy Environmental Technology doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Zhejiang Tengy Environmental Technology's Profit Performance

Zhejiang Tengy Environmental Technology's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Based on these factors, we think that Zhejiang Tengy Environmental Technology's profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into Zhejiang Tengy Environmental Technology, you'd also look into what risks it is currently facing. In terms of investment risks, we've identified 2 warning signs with Zhejiang Tengy Environmental Technology, and understanding these should be part of your investment process.

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 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. 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.