Soft earnings didn't appear to concern Shanghai Xinpeng Industry Co.,Ltd.'s (SZSE:002328) shareholders over the last week. We did some digging, and we believe the earnings are stronger than they seem.

A Closer Look At Shanghai Xinpeng IndustryLtd'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Shanghai Xinpeng IndustryLtd has an accrual ratio of -0.14 for the year to March 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of CN¥558m in the last year, which was a lot more than its statutory profit of CN¥183.4m. Given that Shanghai Xinpeng IndustryLtd had negative free cash flow in the prior corresponding period, the trailing twelve month resul of CN¥558m would seem to be a step in the right direction. Having said that, there is more to the story. 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 Shanghai Xinpeng IndustryLtd.

How Do Unusual Items Influence Profit?

Shanghai Xinpeng IndustryLtd's profit was reduced by unusual items worth CN¥49m 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. Assuming those unusual expenses don't come up again, we'd therefore expect Shanghai Xinpeng IndustryLtd to produce a higher profit next year, all else being equal.

Our Take On Shanghai Xinpeng IndustryLtd's Profit Performance

Considering both Shanghai Xinpeng IndustryLtd's accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think Shanghai Xinpeng IndustryLtd's earnings potential is at least as good as it seems, and maybe even better! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. At Simply Wall St, we found 2 warning signs for Shanghai Xinpeng IndustryLtd and we think they deserve your attention.

Our examination of Shanghai Xinpeng IndustryLtd has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.