Solid Earnings May Not Tell The Whole Story For Xining Special Steel.Co.Ltd (SHSE:600117)

The market shrugged off Xining Special Steel.Co.,Ltd's (SHSE:600117) solid earnings report. We think that investors might be worried about some concerning underlying factors.

View our latest analysis for Xining Special Steel.Co.Ltd

A Closer Look At Xining Special Steel.Co.Ltd's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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. 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, Xining Special Steel.Co.Ltd had an accrual ratio of 0.24. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of CN¥1.69b, a look at free cash flow indicates it actually burnt through CN¥391m in the last year. We saw that FCF was CN¥309m a year ago though, so Xining Special Steel.Co.Ltd has at least been able to generate positive FCF in the past. However, that's not the end of the story. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively. The good news for shareholders is that Xining Special Steel.Co.Ltd's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Xining Special Steel.Co.Ltd.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Xining Special Steel.Co.Ltd issued 211% more new shares over the last year. 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 Xining Special Steel.Co.Ltd's EPS by clicking here.

How Is Dilution Impacting Xining Special Steel.Co.Ltd's Earnings Per Share (EPS)?

As it happens, we don't know how much the company made or lost three years ago, because we don't have the data. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. But mathematics aside, it is always good to see when a formerly unprofitable business come good (though we accept profit would have been higher if dilution had not been required). So you can see that the dilution has had a fairly significant impact on shareholders.

If Xining Special Steel.Co.Ltd'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 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.

How Do Unusual Items Influence Profit?

Xining Special Steel.Co.Ltd's profit suffered from unusual items, which reduced profit by CN¥749m in the last twelve months. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Xining Special Steel.Co.Ltd took a rather significant hit from unusual items in the year to December 2023. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On Xining Special Steel.Co.Ltd's Profit Performance

In conclusion, Xining Special Steel.Co.Ltd's accrual ratio suggests that its statutory earnings are not backed by cash flow; but the fact unusual items actually weighed on profit may create upside if those unusual items to not recur. And the dilution means that per-share results are weaker than the bottom line might imply. After taking into account all the aforementioned observations we think that Xining Special Steel.Co.Ltd's profits probably give a generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Xining Special Steel.Co.Ltd at this point in time. While conducting our analysis, we found that Xining Special Steel.Co.Ltd has 2 warning signs and it would be unwise to ignore them.

Our examination of Xining Special Steel.Co.Ltd 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.