ShenZhen GAD Environmental Technology Co., Ltd.'s (SZSE:300854) stock was strong despite it releasing a soft earnings report last week. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

A Closer Look At ShenZhen GAD Environmental Technology'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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2024, ShenZhen GAD Environmental Technology had an accrual ratio of -0.21. That indicates that its free cash flow quite significantly exceeded its statutory profit. In fact, it had free cash flow of CN¥167m in the last year, which was a lot more than its statutory profit of CN¥14.2m. Given that ShenZhen GAD Environmental Technology had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥167m would seem to be a step in the right direction. 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 ShenZhen GAD Environmental Technology.

How Do Unusual Items Influence Profit?

ShenZhen GAD Environmental Technology's profit was reduced by unusual items worth CN¥28m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. ShenZhen GAD Environmental Technology took a rather significant hit from unusual items in the year to March 2024. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

Our Take On ShenZhen GAD Environmental Technology's Profit Performance

In conclusion, both ShenZhen GAD Environmental Technology's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. After considering all this, we reckon ShenZhen GAD Environmental Technology's statutory profit probably understates its earnings potential! If you'd like to know more about ShenZhen GAD Environmental Technology as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 4 warning signs for ShenZhen GAD Environmental Technology you should be mindful of and 2 of these are a bit concerning.

After our examination into the nature of ShenZhen GAD Environmental Technology's profit, we've come away optimistic for the company. 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.