Why Anhui Zhongyuan New Materials' (SHSE:603527) Soft Earnings Are Just The Beginning Of Its Problems

Shareholders didn't appear too concerned by Anhui Zhongyuan New Materials Co., Ltd.'s (SHSE:603527) weak earnings. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

Check out our latest analysis for Anhui Zhongyuan New Materials

Zooming In On Anhui Zhongyuan New Materials' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 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. 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 March 2024, Anhui Zhongyuan New Materials had an accrual ratio of 0.41. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥107.0m, a look at free cash flow indicates it actually burnt through CN¥746m in the last year. We also note that Anhui Zhongyuan New Materials' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥746m. 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 Anhui Zhongyuan New Materials.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Anhui Zhongyuan New Materials issued 30% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. 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. You can see a chart of Anhui Zhongyuan New Materials' EPS by clicking here.

How Is Dilution Impacting Anhui Zhongyuan New Materials' Earnings Per Share (EPS)?

Anhui Zhongyuan New Materials has improved its profit over the last three years, with an annualized gain of 64% in that time. But EPS was only up 39% per year, in the exact same period. Net profit actually dropped by 24% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 35%. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Anhui Zhongyuan New Materials' 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 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 Anhui Zhongyuan New Materials' Profit Performance

As it turns out, Anhui Zhongyuan New Materials 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). For the reasons mentioned above, we think that a perfunctory glance at Anhui Zhongyuan New Materials' statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Anhui Zhongyuan New Materials as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 5 warning signs for Anhui Zhongyuan New Materials you should be mindful of and 1 of them 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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.