Despite posting some strong earnings, the market for Shenzhen Kedali Industry Co., Ltd.'s (SZSE:002850) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

Examining Cashflow Against Shenzhen Kedali Industry'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. 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.

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

Shenzhen Kedali Industry has an accrual ratio of 0.33 for the year to December 2023. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Over the last year it actually had negative free cash flow of CN¥1.7b, in contrast to the aforementioned profit of CN¥1.20b. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥1.7b, this year, indicates high risk. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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, Shenzhen Kedali Industry increased the number of shares on issue by 15% over the last twelve months by issuing new shares. 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. Check out Shenzhen Kedali Industry's historical EPS growth by clicking on this link.

How Is Dilution Impacting Shenzhen Kedali Industry's Earnings Per Share (EPS)?

As you can see above, Shenzhen Kedali Industry has been growing its net income over the last few years, with an annualized gain of 572% over three years. In comparison, earnings per share only gained 474% over the same period. And at a glance the 34% gain in profit over the last year impresses. But in comparison, EPS only increased by 25% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Shenzhen Kedali Industry can grow EPS persistently. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. 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 Shenzhen Kedali Industry's Profit Performance

In conclusion, Shenzhen Kedali Industry has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. For the reasons mentioned above, we think that a perfunctory glance at Shenzhen Kedali Industry's statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To that end, you should learn about the 3 warning signs we've spotted with Shenzhen Kedali Industry (including 1 which is potentially serious).

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 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.