Shareholders didn't appear too concerned by CSSC Science& Technology Co., Ltd's (SHSE:600072) weak earnings. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

A Closer Look At CSSC Science& 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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".

CSSC Science& Technology has an accrual ratio of 0.68 for the year to March 2024. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of CN¥9.6b, in contrast to the aforementioned profit of CN¥102.4m. We also note that CSSC Science& Technology's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥9.6b. 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 CSSC Science& Technology.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. CSSC Science& Technology expanded the number of shares on issue by 105% over the last year. That means its earnings are split among a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. You can see a chart of CSSC Science& Technology's EPS by clicking here.

A Look At The Impact Of CSSC Science& Technology's Dilution On Its Earnings Per Share (EPS)

Unfortunately, CSSC Science& Technology's profit is down 27% per year over three years. And even focusing only on the last twelve months, we see profit is down 61%. Sadly, earnings per share fell further, down a full 56% in that time. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

If CSSC Science& Technology's 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

Given the accrual ratio, it's not overly surprising that CSSC Science& Technology's profit was boosted by unusual items worth CN¥23m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. We can see that CSSC Science& Technology's positive unusual items were quite significant relative to its profit in the year to March 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On CSSC Science& Technology's Profit Performance

In conclusion, CSSC Science& Technology's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. For all the reasons mentioned above, we think that, at a glance, CSSC Science& Technology's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Be aware that CSSC Science& Technology is showing 4 warning signs in our investment analysis and 3 of those can't be ignored...

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. 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.