Beyond Lackluster Earnings: Potential Concerns For Yueyang Xingchang Petro-Chemical's (SZSE:000819) Shareholders

Shareholders didn't appear too concerned by Yueyang Xingchang Petro-Chemical Co., Ltd.'s (SZSE:000819) weak earnings. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

See our latest analysis for Yueyang Xingchang Petro-Chemical

Examining Cashflow Against Yueyang Xingchang Petro-Chemical'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. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Yueyang Xingchang Petro-Chemical has an accrual ratio of 0.31 for the year to September 2024. 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¥455m, in contrast to the aforementioned profit of CN¥100.0m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥455m, this year, indicates high risk. Having said that, there is more to consider. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Yueyang Xingchang Petro-Chemical.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Yueyang Xingchang Petro-Chemical expanded the number of shares on issue by 20% over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Yueyang Xingchang Petro-Chemical's EPS by clicking here.

A Look At The Impact Of Yueyang Xingchang Petro-Chemical's Dilution On Its Earnings Per Share (EPS)

As you can see above, Yueyang Xingchang Petro-Chemical has been growing its net income over the last few years, with an annualized gain of 90% over three years. But EPS was only up 67% per year, in the exact same period. Net profit actually dropped by 3.3% in the last year. But the EPS result was even worse, with the company recording a decline of 16%. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Yueyang Xingchang Petro-Chemical'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?

The fact that the company had unusual items boosting profit by CN¥17m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Yueyang Xingchang Petro-Chemical's Profit Performance

Yueyang Xingchang Petro-Chemical didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. For all the reasons mentioned above, we think that, at a glance, Yueyang Xingchang Petro-Chemical's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Be aware that Yueyang Xingchang Petro-Chemical is showing 3 warning signs in our investment analysis and 1 of those is potentially serious...

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 are plenty of other ways to inform your opinion of a company. 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

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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.