Shenzhen Zhongzhuang Construction Group Co.,Ltd's (SZSE:002822) recent soft profit numbers didn't appear to worry shareholders. However, we think the company is showing some signs that things are more promising than they seem.

See our latest analysis for Shenzhen Zhongzhuang Construction GroupLtd

A Closer Look At Shenzhen Zhongzhuang Construction GroupLtd's 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Shenzhen Zhongzhuang Construction GroupLtd has an accrual ratio of 0.21 for the year to December 2021. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥766m, in contrast to the aforementioned profit of CN¥106.4m. We also note that Shenzhen Zhongzhuang Construction GroupLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥766m. 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 Zhongzhuang Construction GroupLtd.

The Impact Of Unusual Items On Profit

Shenzhen Zhongzhuang Construction GroupLtd's profit suffered from unusual items, which reduced profit by CN¥186m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. 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 that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Shenzhen Zhongzhuang Construction GroupLtd to produce a higher profit next year, all else being equal.

Our Take On Shenzhen Zhongzhuang Construction GroupLtd's Profit Performance

In conclusion, Shenzhen Zhongzhuang Construction GroupLtd's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, we think that Shenzhen Zhongzhuang Construction GroupLtd's profits are a reasonably conservative guide to its underlying profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. When we did our research, we found 4 warning signs for Shenzhen Zhongzhuang Construction GroupLtd (1 shouldn't be ignored!) that we believe deserve your full attention.

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. 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.