The market shrugged off Zhejiang Fulai New Material Co.,Ltd.'s (SHSE:605488) weak earnings report. While shares were up, we believe there are some factors in the earnings report that might cause investors some concerns.

A Closer Look At Zhejiang Fulai New MaterialLtd'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). 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.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Zhejiang Fulai New MaterialLtd has an accrual ratio of 0.52 for the year to December 2023. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of CN¥584m, in contrast to the aforementioned profit of CN¥70.1m. We also note that Zhejiang Fulai New MaterialLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥584m. 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 Zhejiang Fulai New MaterialLtd.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Zhejiang Fulai New MaterialLtd issued 7.8% more new shares 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 Zhejiang Fulai New MaterialLtd's EPS by clicking here.

How Is Dilution Impacting Zhejiang Fulai New MaterialLtd's Earnings Per Share (EPS)?

Zhejiang Fulai New MaterialLtd's net profit dropped by 42% per year over the last three years. And even focusing only on the last twelve months, we see profit is down 7.0%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 7.8% in the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if Zhejiang Fulai New MaterialLtd's earnings per share can increase, then the share price should too. 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 Zhejiang Fulai New MaterialLtd's Profit Performance

As it turns out, Zhejiang Fulai New MaterialLtd 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). Considering all this we'd argue Zhejiang Fulai New MaterialLtd's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Zhejiang Fulai New MaterialLtd at this point in time. For example, Zhejiang Fulai New MaterialLtd has 5 warning signs (and 2 which don't sit too well with us) we think you should know about.

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.