Investors were underwhelmed by the solid earnings posted by China Tangshang Holdings Limited (HKG:674) recently. We have done some analysis and have found some comforting factors beneath the profit numbers.

See our latest analysis for China Tangshang Holdings

Examining Cashflow Against China Tangshang Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. 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 March 2022, China Tangshang Holdings recorded an accrual ratio of -0.61. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of HK$355m during the period, dwarfing its reported profit of HK$8.02m. Notably, China Tangshang Holdings had negative free cash flow last year, so the HK$355m it produced this year was a welcome improvement. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of China Tangshang Holdings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, China Tangshang Holdings issued 25% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of China Tangshang Holdings' EPS by clicking here.

A Look At The Impact Of China Tangshang Holdings' Dilution On Its Earnings Per Share (EPS)

Three years ago, China Tangshang Holdings lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

If China Tangshang Holdings' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

The Impact Of Unusual Items On Profit

China Tangshang Holdings' profit was reduced by unusual items worth HK$21m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect China Tangshang Holdings to produce a higher profit next year, all else being equal.

Our Take On China Tangshang Holdings' Profit Performance

Summing up, China Tangshang Holdings' accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed (and could bounce back), while the dilution is a negative for shareholders. Looking at all these factors, we'd say that China Tangshang Holdings' underlying earnings power is at least as good as the statutory numbers would make it seem. So while earnings quality is important, it's equally important to consider the risks facing China Tangshang Holdings at this point in time. For example, China Tangshang Holdings has 4 warning signs (and 1 which is concerning) we think you should know about.

Our examination of China Tangshang Holdings has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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.