After announcing healthy earnings, FESCO Group Co., Ltd.'s (SHSE:600861) stock rose over the last week. However, we think that shareholders should be aware of some other factors beyond the profit numbers.

Zooming In On FESCO Group's 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. 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.

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".

Over the twelve months to March 2024, FESCO Group recorded an accrual ratio of 0.69. 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¥498.8m, a look at free cash flow indicates it actually burnt through CN¥349m in the last year. We also note that FESCO Group's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥349m. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings. One positive for FESCO Group shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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. FESCO Group expanded the number of shares on issue by 20% 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 FESCO Group's EPS by clicking here.

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

FESCO Group was losing money three years ago. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. Therefore, the dilution is having a noteworthy influence on shareholder returns.

If FESCO Group'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 FESCO Group's Profit Performance

As it turns out, FESCO Group couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). For the reasons mentioned above, we think that a perfunctory glance at FESCO Group's statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into FESCO Group, you'd also look into what risks it is currently facing. When we did our research, we found 2 warning signs for FESCO Group (1 is potentially serious!) 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. 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.