Investors were underwhelmed by the solid earnings posted by Harbin Electric Company Limited (HKG:1133) recently. Our analysis says that investors should be optimistic, as the strong profit is built on solid foundations.
Examining Cashflow Against Harbin Electric's Earnings
Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.
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. 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 December 2023, Harbin Electric recorded an accrual ratio of -0.32. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. In fact, it had free cash flow of CN¥1.2b in the last year, which was a lot more than its statutory profit of CN¥574.8m. Harbin Electric's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. Unfortunately for shareholders, the company has also been issuing new shares, diluting 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. In fact, Harbin Electric increased the number of shares on issue by 31% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Harbin Electric's EPS by clicking here.
A Look At The Impact Of Harbin Electric's Dilution On Its Earnings Per Share (EPS)
Three years ago, Harbin Electric lost money. The good news is that profit was up 483% in the last twelve months. But EPS was less impressive, up only 439% 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 Harbin Electric 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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.
Our Take On Harbin Electric's Profit Performance
In conclusion, Harbin Electric has strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share growth is weaker than its profit growth. Based on these factors, we think that Harbin Electric's profits are a reasonably conservative guide to its underlying profitability. If you want to do dive deeper into Harbin Electric, you'd also look into what risks it is currently facing. Case in point: We've spotted 2 warning signs for Harbin Electric you should be aware of.
Our examination of Harbin Electric has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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.