Despite posting some strong earnings, the market for Zhongzhi Pharmaceutical Holdings Limited's (HKG:3737) stock hasn't moved much. We did some digging, and we found some concerning factors in the details.

Examining Cashflow Against Zhongzhi Pharmaceutical Holdings' 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'.

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. 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. 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 December 2023, Zhongzhi Pharmaceutical Holdings had an accrual ratio of 0.30. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥162.8m, a look at free cash flow indicates it actually burnt through CN¥70m in the last year. We saw that FCF was CN¥195m a year ago though, so Zhongzhi Pharmaceutical Holdings has at least been able to generate positive FCF in the past. The good news for shareholders is that Zhongzhi Pharmaceutical Holdings' 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhongzhi Pharmaceutical Holdings.

Our Take On Zhongzhi Pharmaceutical Holdings' Profit Performance

Zhongzhi Pharmaceutical Holdings didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Because of this, we think that it may be that Zhongzhi Pharmaceutical Holdings' statutory profits are better than its underlying earnings power. Nonetheless, it's still worth noting that its earnings per share have grown at 15% over the last three years. 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. If you'd like to know more about Zhongzhi Pharmaceutical Holdings as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 2 warning signs for Zhongzhi Pharmaceutical Holdings (of which 1 is potentially serious!) you should know about.

Today we've zoomed in on a single data point to better understand the nature of Zhongzhi Pharmaceutical Holdings' 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. 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.