The subdued market reaction suggests that Gansu Energy Chemical Co., Ltd.'s (SZSE:000552) recent earnings didn't contain any surprises. However, we believe that investors should be aware of some underlying factors which may be of concern.

Zooming In On Gansu Energy Chemical'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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

For the year to December 2023, Gansu Energy Chemical had an accrual ratio of 0.26. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥1.2b despite its profit of CN¥1.74b, mentioned above. We saw that FCF was CN¥2.4b a year ago though, so Gansu Energy Chemical has at least been able to generate positive FCF in the past. 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. As it happens, Gansu Energy Chemical issued 16% more new shares 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. You can see a chart of Gansu Energy Chemical's EPS by clicking here.

How Is Dilution Impacting Gansu Energy Chemical's Earnings Per Share (EPS)?

Gansu Energy Chemical has improved its profit over the last three years, with an annualized gain of 290% in that time. But EPS was only up 90% per year, in the exact same period. Net profit actually dropped by 45% in the last year. But the EPS result was even worse, with the company recording a decline of 53%. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, if Gansu Energy Chemical's earnings per share can increase, then the share price should too. 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 Gansu Energy Chemical's Profit Performance

As it turns out, Gansu Energy Chemical 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 Gansu Energy Chemical's profits probably give an overly generous impression of its sustainable level of profitability. If you want to do dive deeper into Gansu Energy Chemical, you'd also look into what risks it is currently facing. Case in point: We've spotted 4 warning signs for Gansu Energy Chemical you should be mindful of and 1 of them can't be ignored.

Our examination of Gansu Energy Chemical has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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.