ShenZhen GAD Environmental Technology Co., Ltd. (SZSE:300854) recently posted soft earnings but shareholders didn't react strongly. Our analysis suggests that they may be missing some concerning details underlying the profit numbers.

View our latest analysis for ShenZhen GAD Environmental Technology

Zooming In On ShenZhen GAD Environmental Technology'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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 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.

For the year to March 2022, ShenZhen GAD Environmental Technology had an accrual ratio of 0.32. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Over the last year it actually had negative free cash flow of CN¥102m, in contrast to the aforementioned profit of CN¥83.9m. It's worth noting that ShenZhen GAD Environmental Technology generated positive FCF of CN¥10m a year ago, so at least they've done it in the past. 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 ShenZhen GAD Environmental Technology.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥27m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. We can see that ShenZhen GAD Environmental Technology's positive unusual items were quite significant relative to its profit in the year to March 2022. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On ShenZhen GAD Environmental Technology's Profit Performance

Summing up, ShenZhen GAD Environmental Technology received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. For the reasons mentioned above, we think that a perfunctory glance at ShenZhen GAD Environmental Technology's statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. Our analysis shows 2 warning signs for ShenZhen GAD Environmental Technology (1 shouldn't be ignored!) and we strongly recommend you look at them before investing.

Our examination of ShenZhen GAD Environmental 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 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.