Gansu Energy Chemical's (SZSE:000552) Weak Earnings May Only Reveal A Part Of The Whole Picture

Gansu Energy Chemical Co., Ltd.'s (SZSE:000552) recent weak earnings report didn't cause a big stock movement. We think that investors are worried about some weaknesses underlying the earnings.

View our latest analysis for Gansu Energy Chemical

Examining Cashflow Against Gansu Energy Chemical's 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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

Gansu Energy Chemical has an accrual ratio of 0.26 for the year to December 2023. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥1.2b, in contrast to the aforementioned profit of CN¥1.74b. It's worth noting that Gansu Energy Chemical generated positive FCF of CN¥2.4b a year ago, so at least they've done it 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.

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 16% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. 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. Check out Gansu Energy Chemical's historical EPS growth by clicking on this link.

How Is Dilution Impacting Gansu Energy Chemical's 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 290% over three years. In comparison, earnings per share only gained 90% over the same period. Net profit actually dropped by 45% in the last year. 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.

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

In conclusion, Gansu Energy Chemical 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 Gansu Energy Chemical's profits probably give an overly generous impression of its sustainable level of profitability. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Our analysis shows 4 warning signs for Gansu Energy Chemical (1 shouldn't be ignored!) and we strongly recommend you look at them before investing.

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. 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.