A lackluster earnings announcement from Zhejiang Zone-King Environmental Sci&Tech Co., Ltd. (SHSE:688701) 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.

Check out our latest analysis for Zhejiang Zone-King Environmental Sci&Tech

Zooming In On Zhejiang Zone-King Environmental Sci&Tech's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Zhejiang Zone-King Environmental Sci&Tech has an accrual ratio of 0.28 for the year to March 2022. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥40.2m, a look at free cash flow indicates it actually burnt through CN¥70m in the last year. We also note that Zhejiang Zone-King Environmental Sci&Tech's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥70m.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhejiang Zone-King Environmental Sci&Tech.

Our Take On Zhejiang Zone-King Environmental Sci&Tech's Profit Performance

Zhejiang Zone-King Environmental Sci&Tech's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Zhejiang Zone-King Environmental Sci&Tech's statutory profits are better than its underlying earnings power. In further bad news, its earnings per share decreased in the last year. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. So while earnings quality is important, it's equally important to consider the risks facing Zhejiang Zone-King Environmental Sci&Tech at this point in time. Case in point: We've spotted 3 warning signs for Zhejiang Zone-King Environmental Sci&Tech you should be mindful of and 1 of these doesn't sit too well with us.

Today we've zoomed in on a single data point to better understand the nature of Zhejiang Zone-King Environmental Sci&Tech's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. 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. 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.