Last week's earnings announcement from Shanghai Supezet Engineering Technology Corp., Ltd. (SHSE:688121) was disappointing to investors, with a sluggish profit figure. Our analysis has found some reasons to be concerned, beyond the weak headline numbers.

Examining Cashflow Against Shanghai Supezet Engineering Technology'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. 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'.

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. 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".

Shanghai Supezet Engineering Technology has an accrual ratio of 0.32 for the year to December 2023. 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. Over the last year it actually had negative free cash flow of CN¥1.1b, in contrast to the aforementioned profit of CN¥154.0m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥1.1b, this year, indicates high risk. 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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Shanghai Supezet Engineering Technology expanded the number of shares on issue by 15% over the last year. 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 Supezet Engineering Technology's EPS by clicking here.

How Is Dilution Impacting Shanghai Supezet Engineering Technology's Earnings Per Share (EPS)?

Unfortunately, Shanghai Supezet Engineering Technology's profit is down 38% per year over three years. Even looking at the last year, profit was still down 14%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 15% in the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Shanghai Supezet Engineering Technology'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 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 Supezet Engineering Technology's Profit Performance

In conclusion, Shanghai Supezet Engineering Technology 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 Supezet Engineering Technology's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Shanghai Supezet Engineering Technology, you'd also look into what risks it is currently facing. To that end, you should learn about the 5 warning signs we've spotted with Shanghai Supezet Engineering Technology (including 2 which don't sit too well with us).

Our examination of Shanghai Supezet Engineering Technology 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 is always more to discover if you are capable of focussing your mind on minutiae. 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.