Last week's earnings announcement from Shanghai Putailai New Energy Technology Co.,Ltd. (SHSE:603659) was disappointing to investors, with a sluggish profit figure. We did some analysis, and found that there are some reasons to be cautious about the headline numbers.

Zooming In On Shanghai Putailai New Energy TechnologyLtd'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2024, Shanghai Putailai New Energy TechnologyLtd had an accrual ratio of 0.32. 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¥1.65b, a look at free cash flow indicates it actually burnt through CN¥3.9b in the last year. We also note that Shanghai Putailai New Energy TechnologyLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥3.9b. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. In fact, Shanghai Putailai New Energy TechnologyLtd increased the number of shares on issue by 5.5% over the last twelve months by issuing new shares. As a result, its net income is now split between a greater number of shares. 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 Shanghai Putailai New Energy TechnologyLtd's EPS by clicking here.

How Is Dilution Impacting Shanghai Putailai New Energy TechnologyLtd's Earnings Per Share (EPS)?

As you can see above, Shanghai Putailai New Energy TechnologyLtd has been growing its net income over the last few years, with an annualized gain of 82% over three years. In comparison, earnings per share only gained 65% over the same period. Net profit actually dropped by 48% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 48%. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if Shanghai Putailai New Energy TechnologyLtd's earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

Our Take On Shanghai Putailai New Energy TechnologyLtd's Profit Performance

In conclusion, Shanghai Putailai New Energy TechnologyLtd 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 Putailai New Energy TechnologyLtd's statutory profits might make it look better than it really is on an underlying level. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, Shanghai Putailai New Energy TechnologyLtd has 4 warning signs (and 1 which can't be ignored) we think you should know about.

Our examination of Shanghai Putailai New Energy TechnologyLtd 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 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.