Zhiyang Innovation Technology Co., Ltd.'s (SHSE:688191) stock wasn't much affected by its recent lackluster earnings numbers. Our analysis suggests that they may be missing some concerning details underlying the profit numbers.

See our latest analysis for Zhiyang Innovation Technology

A Closer Look At Zhiyang Innovation 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Zhiyang Innovation Technology has an accrual ratio of 0.61 for the year to March 2022. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥135m, in contrast to the aforementioned profit of CN¥88.0m. It's worth noting that Zhiyang Innovation Technology generated positive FCF of CN¥18m a year ago, so at least they've done it in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Zhiyang Innovation Technology.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥18m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. If Zhiyang Innovation 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 Zhiyang Innovation Technology's Profit Performance

Zhiyang Innovation Technology had a weak accrual ratio, but its profit did receive a boost from unusual items. For the reasons mentioned above, we think that a perfunctory glance at Zhiyang Innovation Technology's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Zhiyang Innovation Technology at this point in time. When we did our research, we found 4 warning signs for Zhiyang Innovation Technology (1 makes us a bit uncomfortable!) that we believe deserve your full attention.

Our examination of Zhiyang Innovation Technology has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there are plenty of other ways to inform your opinion of a company. 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.