We didn't see Sineng Electric Co.,Ltd.'s (SZSE:300827) stock surge when it reported robust earnings recently. We think that investors might be worried about the foundations the earnings are built on.

Zooming In On Sineng ElectricLtd'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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to March 2024, Sineng ElectricLtd recorded an accrual ratio of 0.71. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥300.4m, a look at free cash flow indicates it actually burnt through CN¥411m in the last year. We also note that Sineng ElectricLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥411m. 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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Sineng ElectricLtd issued 5.4% more new shares over the last year. That means its earnings are split among 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 Sineng ElectricLtd's EPS by clicking here.

A Look At The Impact Of Sineng ElectricLtd's Dilution On Its Earnings Per Share (EPS)

As you can see above, Sineng ElectricLtd has been growing its net income over the last few years, with an annualized gain of 305% over three years. In comparison, earnings per share only gained 282% over the same period. And at a glance the 195% gain in profit over the last year impresses. But in comparison, EPS only increased by 178% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Sineng ElectricLtd can grow EPS persistently. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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 Sineng ElectricLtd's Profit Performance

As it turns out, Sineng ElectricLtd couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For the reasons mentioned above, we think that a perfunctory glance at Sineng ElectricLtd'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 Sineng ElectricLtd at this point in time. When we did our research, we found 2 warning signs for Sineng ElectricLtd (1 is significant!) that we believe deserve your full attention.

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 is always more to discover if you are capable of focussing your mind on minutiae. 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. 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.