Zhangjiagang Haiguo New Energy Equipment Manufacturing Co., Ltd. (SZSE:301063) recently posted soft earnings but shareholders didn't react strongly. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

Check out our latest analysis for Zhangjiagang Haiguo New Energy Equipment Manufacturing

A Closer Look At Zhangjiagang Haiguo New Energy Equipment Manufacturing's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. 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.

Zhangjiagang Haiguo New Energy Equipment Manufacturing has an accrual ratio of 0.28 for the year to March 2022. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Even though it reported a profit of CN¥69.2m, a look at free cash flow indicates it actually burnt through CN¥143m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥143m, this year, indicates high risk. 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 Zhangjiagang Haiguo New Energy Equipment Manufacturing.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Zhangjiagang Haiguo New Energy Equipment Manufacturing's profit was boosted by unusual items worth CN¥22m in the last twelve months. 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 that's as you'd expect, given these boosts are described as 'unusual'. We can see that Zhangjiagang Haiguo New Energy Equipment Manufacturing'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 Zhangjiagang Haiguo New Energy Equipment Manufacturing's Profit Performance

Zhangjiagang Haiguo New Energy Equipment Manufacturing had a weak accrual ratio, but its profit did receive a boost from unusual items. Considering all this we'd argue Zhangjiagang Haiguo New Energy Equipment Manufacturing's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Zhangjiagang Haiguo New Energy Equipment Manufacturing, you'd also look into what risks it is currently facing. For example, we've found that Zhangjiagang Haiguo New Energy Equipment Manufacturing has 4 warning signs (1 is concerning!) that deserve your attention before going any further with your analysis.

Our examination of Zhangjiagang Haiguo New Energy Equipment Manufacturing 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.