We're Not Counting On Zhenro Services Group (HKG:6958) To Sustain Its Statutory Profitability

Broadly speaking, profitable businesses are less risky than unprofitable ones. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. In this article, we'll look at how useful this year's statutory profit is, when analysing Zhenro Services Group (HKG:6958).

We like the fact that Zhenro Services Group made a profit of CN¥136.1m on its revenue of CN¥864.3m, in the last year.

See our latest analysis for Zhenro Services Group

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. Today, we'll discuss Zhenro Services Group's free cashflow relative to its earnings, and consider what that tells us about the company. 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.

Examining Cashflow Against Zhenro Services Group'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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. 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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2020, Zhenro Services Group had an accrual ratio of 0.44. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. To wit, it produced free cash flow of CN¥85m during the period, falling well short of its reported profit of CN¥136.1m. Notably Zhenro Services Group's free cash flow was stable over the last year. The good news for shareholders is that Zhenro Services Group's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Our Take On Zhenro Services Group's Profit Performance

As we discussed above, we think Zhenro Services Group's earnings were not supported by free cash flow, which might concern some investors. For this reason, we think that Zhenro Services Group's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To that end, you should learn about the 2 warning signs we've spotted with Zhenro Services Group (including 1 which makes us a bit uncomfortable).

This note has only looked at a single factor that sheds light on the nature of Zhenro Services Group's profit. 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. 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.
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