Guangdong Construction Engineering Group's (SZSE:002060) Weak Earnings May Only Reveal A Part Of The Whole Picture

The subdued market reaction suggests that Guangdong Construction Engineering Group Co., Ltd.'s (SZSE:002060) recent earnings didn't contain any surprises. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

See our latest analysis for Guangdong Construction Engineering Group

A Closer Look At Guangdong Construction Engineering Group'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.

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

For the year to December 2023, Guangdong Construction Engineering Group had an accrual ratio of 0.32. 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¥5.1b, in contrast to the aforementioned profit of CN¥1.53b. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥5.1b, 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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Guangdong Construction Engineering Group increased the number of shares on issue by 11% over the last twelve months by issuing new shares. 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 Guangdong Construction Engineering Group's EPS by clicking here.

How Is Dilution Impacting Guangdong Construction Engineering Group's Earnings Per Share (EPS)?

Guangdong Construction Engineering Group has improved its profit over the last three years, with an annualized gain of 482% in that time. But EPS was only up 96% per year, in the exact same period. Net profit actually dropped by 9.9% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 15%. Therefore, the dilution is having a noteworthy influence on shareholder returns.

If Guangdong Construction Engineering Group's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Guangdong Construction Engineering Group's Profit Performance

In conclusion, Guangdong Construction Engineering Group has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue Guangdong Construction Engineering Group'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 Guangdong Construction Engineering Group at this point in time. Every company has risks, and we've spotted 4 warning signs for Guangdong Construction Engineering Group (of which 2 are concerning!) you should know about.

Our examination of Guangdong Construction Engineering Group 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 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. 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.