Shanghai Wondertek Software Co., Ltd's (SHSE:603189) weak earnings were disregarded by the market. Despite the market responding positively, we think that there are several concerning factors that investors should be aware of.

View our latest analysis for Shanghai Wondertek Software

Examining Cashflow Against Shanghai Wondertek Software'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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.

Over the twelve months to March 2022, Shanghai Wondertek Software recorded an accrual ratio of 0.38. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥208m despite its profit of CN¥67.7m, mentioned above. We also note that Shanghai Wondertek Software's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥208m. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Shanghai Wondertek Software.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Shanghai Wondertek Software expanded the number of shares on issue by 22% over the last year. Therefore, each share now receives a smaller portion of profit. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Shanghai Wondertek Software's historical EPS growth by clicking on this link.

A Look At The Impact Of Shanghai Wondertek Software's Dilution on Its Earnings Per Share (EPS).

As you can see above, Shanghai Wondertek Software has been growing its net income over the last few years, with an annualized gain of 165% over three years. But EPS was only up 112% per year, in the exact same period. Net income was down 13% over the last twelve months. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 22%. Therefore, the dilution is having a noteworthy influence on shareholder returns.

If Shanghai Wondertek Software's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Shanghai Wondertek Software's Profit Performance

In conclusion, Shanghai Wondertek Software has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). For the reasons mentioned above, we think that a perfunctory glance at Shanghai Wondertek Software's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Shanghai Wondertek Software at this point in time. Be aware that Shanghai Wondertek Software is showing 3 warning signs in our investment analysis and 1 of those is significant...

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.