There Might Be More To Zhejiang Fulai New MaterialLtd's (SHSE:605488) Story Than Just Weak Earnings

Zhejiang Fulai New Material Co.,Ltd.'s (SHSE:605488) weak earnings were disregarded by the market. Despite the market responding positively, we think that there are several concerning factors that investors should be aware of.

Check out our latest analysis for Zhejiang Fulai New MaterialLtd

Zooming In On Zhejiang Fulai New MaterialLtd'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). 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.

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. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. 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, Zhejiang Fulai New MaterialLtd had an accrual ratio of 0.52. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥584m despite its profit of CN¥70.1m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥584m, this year, indicates high risk. 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 Zhejiang Fulai New MaterialLtd.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Zhejiang Fulai New MaterialLtd expanded the number of shares on issue by 7.8% over the last year. As a result, its net income is now split between a greater number of shares. 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. Check out Zhejiang Fulai New MaterialLtd's historical EPS growth by clicking on this link.

A Look At The Impact Of Zhejiang Fulai New MaterialLtd's Dilution On Its Earnings Per Share (EPS)

Unfortunately, Zhejiang Fulai New MaterialLtd's profit is down 42% per year over three years. Even looking at the last year, profit was still down 7.0%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 7.8% in the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, if Zhejiang Fulai New MaterialLtd's earnings per share can increase, then the share price should too. 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 Zhejiang Fulai New MaterialLtd's Profit Performance

In conclusion, Zhejiang Fulai New MaterialLtd 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). For the reasons mentioned above, we think that a perfunctory glance at Zhejiang Fulai New MaterialLtd's statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For instance, we've identified 5 warning signs for Zhejiang Fulai New MaterialLtd (2 are a bit concerning) you should be familiar with.

Our examination of Zhejiang Fulai New MaterialLtd 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. 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.