abc Multiactive Limited's (HKG:8131) stock rose after it released a robust earnings report. While the headline numbers were strong, we found some underlying problems once we started looking at what drove earnings.

Check out our latest analysis for abc Multiactive

Examining Cashflow Against abc Multiactive's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to May 2022, abc Multiactive recorded an accrual ratio of 1.47. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of HK$5.5m during the period, falling well short of its reported profit of HK$25.3m. At this point we should mention that abc Multiactive did manage to increase its free cash flow in the last twelve months Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of abc Multiactive.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. abc Multiactive expanded the number of shares on issue by 58% 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 abc Multiactive's EPS by clicking here.

A Look At The Impact Of abc Multiactive's Dilution on Its Earnings Per Share (EPS).

Three years ago, abc Multiactive lost money. The good news is that profit was up 846% in the last twelve months. But EPS was less impressive, up only 550% in that time. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if abc Multiactive can grow EPS persistently. 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 abc Multiactive's Profit Performance

As it turns out, abc Multiactive couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For all the reasons mentioned above, we think that, at a glance, abc Multiactive's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. So while earnings quality is important, it's equally important to consider the risks facing abc Multiactive at this point in time. At Simply Wall St, we found 4 warning signs for abc Multiactive and we think they deserve your 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.