Gansu Energy Chemical's (SZSE:000552) Sluggish Earnings Might Be Just The Beginning Of Its Problems

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.

See our latest analysis for Gansu Energy Chemical

Examining Cashflow Against Gansu Energy Chemical's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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'.

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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Gansu Energy Chemical has an accrual ratio of 0.29 for the year to September 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Over the last year it actually had negative free cash flow of CN¥3.1b, in contrast to the aforementioned profit of CN¥1.21b. We also note that Gansu Energy Chemical's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥3.1b. 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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Gansu Energy Chemical increased the number of shares on issue by 17% over the last twelve months by issuing new shares. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Gansu Energy Chemical's EPS by clicking here.

A Look At The Impact Of Gansu Energy Chemical's Dilution On Its Earnings Per Share (EPS)

As you can see above, Gansu Energy Chemical has been growing its net income over the last few years, with an annualized gain of 120% over three years. In contrast, earnings per share were actually down by 4.4% per year, in the exact same period. Net income was down 40% over the last twelve months. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 53%. Therefore, the dilution is having a noteworthy influence on shareholder returns.

If Gansu Energy Chemical's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. 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 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. So while earnings quality is important, it's equally important to consider the risks facing Gansu Energy Chemical at this point in time. Case in point: We've spotted 4 warning signs for Gansu Energy Chemical you should be mindful of and 1 of these bad boys doesn't sit too well with us.

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 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 with high insider ownership.

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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.