Despite posting some strong earnings, the market for Guizhou Zhenhua New Material Co., Ltd.'s (SHSE:688707) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

See our latest analysis for Guizhou Zhenhua New Material

Zooming In On Guizhou Zhenhua New Material'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2021, Guizhou Zhenhua New Material recorded an accrual ratio of 0.20. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥202m, in contrast to the aforementioned profit of CN¥412.6m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥202m, this year, indicates high risk.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

Our Take On Guizhou Zhenhua New Material's Profit Performance

Guizhou Zhenhua New Material didn't convert much of its profit to free cash flow in the last year, which some investors may consider rather suboptimal. Therefore, it seems possible to us that Guizhou Zhenhua New Material's true underlying earnings power is actually less than its statutory profit. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Guizhou Zhenhua New Material at this point in time. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Guizhou Zhenhua New Material.

This note has only looked at a single factor that sheds light on the nature of Guizhou Zhenhua New Material's profit. 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. 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.