Shareholders were pleased with the recent earnings report from Suzhou Veichi Electric Co., Ltd. (SHSE:688698). Despite this, we feel that there are some reasons to be cautious with these earnings.

A Closer Look At Suzhou Veichi Electric'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. 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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Suzhou Veichi Electric has an accrual ratio of 0.36 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. Even though it reported a profit of CN¥190.8m, a look at free cash flow indicates it actually burnt through CN¥177m in the last year. We saw that FCF was CN¥89m a year ago though, so Suzhou Veichi Electric has at least been able to generate positive FCF in the past. 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. Suzhou Veichi Electric expanded the number of shares on issue by 17% over the last year. Therefore, each share now receives a smaller portion of profit. 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. Check out Suzhou Veichi Electric's historical EPS growth by clicking on this link.

How Is Dilution Impacting Suzhou Veichi Electric's Earnings Per Share (EPS)?

As you can see above, Suzhou Veichi Electric has been growing its net income over the last few years, with an annualized gain of 118% over three years. In comparison, earnings per share only gained 57% over the same period. And at a glance the 36% gain in profit over the last year impresses. But in comparison, EPS only increased by 31% over the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, earnings per share growth should beget share price growth. So Suzhou Veichi Electric shareholders will want to see that EPS figure continue to increase. 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 Suzhou Veichi Electric's Profit Performance

As it turns out, Suzhou Veichi Electric couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. Considering all this we'd argue Suzhou Veichi Electric's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Suzhou Veichi Electric as a business, it's important to be aware of any risks it's facing. Be aware that Suzhou Veichi Electric is showing 3 warning signs in our investment analysis and 1 of those 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. 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.