Zensun Enterprises Limited's (HKG:185) recent soft profit numbers didn't appear to worry shareholders. Our analysis suggests that investors may have noticed some promising signs beyond the statutory profit figures.

See our latest analysis for Zensun Enterprises

Examining Cashflow Against Zensun Enterprises' 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. 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. 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 December 2021, Zensun Enterprises had an accrual ratio of -0.17. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of CN¥5.5b during the period, dwarfing its reported profit of CN¥399.5m. Zensun Enterprises shareholders are no doubt pleased that free cash flow improved over the last twelve months. 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 Zensun Enterprises.

The Impact Of Unusual Items On Profit

Surprisingly, given Zensun Enterprises' accrual ratio implied strong cash conversion, its paper profit was actually boosted by CN¥113m in unusual items. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. If Zensun Enterprises 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 Zensun Enterprises' Profit Performance

In conclusion, Zensun Enterprises' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Considering the aforementioned, we think that Zensun Enterprises' profits are probably a reasonable reflection of its underlying profitability; although we'd be confident in that conclusion if we saw a cleaner set of results. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, we've discovered 4 warning signs that you should run your eye over to get a better picture of Zensun Enterprises.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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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.