There Are Some Reasons To Suggest That Yueyang Xingchang Petro-Chemical's (SZSE:000819) Earnings Are A Poor Reflection Of Profitability

Solid profit numbers didn't seem to be enough to please Yueyang Xingchang Petro-Chemical Co., Ltd.'s (SZSE:000819) shareholders. We think that they might be concerned about some underlying details that our analysis found.

View our latest analysis for Yueyang Xingchang Petro-Chemical

Examining Cashflow Against Yueyang Xingchang Petro-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. 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. The ratio shows us how much a company's profit exceeds its FCF.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Yueyang Xingchang Petro-Chemical recorded an accrual ratio of 0.58. 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. Over the last year it actually had negative free cash flow of CN¥652m, in contrast to the aforementioned profit of CN¥101.1m. We also note that Yueyang Xingchang Petro-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¥652m. 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 Yueyang Xingchang Petro-Chemical.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Yueyang Xingchang Petro-Chemical expanded the number of shares on issue by 21% over the last year. That means its earnings are split among 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 Yueyang Xingchang Petro-Chemical's historical EPS growth by clicking on this link.

How Is Dilution Impacting Yueyang Xingchang Petro-Chemical's Earnings Per Share (EPS)?

Yueyang Xingchang Petro-Chemical has improved its profit over the last three years, with an annualized gain of 272% in that time. And at a glance the 26% gain in profit over the last year impresses. But in comparison, EPS only increased by 27% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So Yueyang Xingchang Petro-Chemical shareholders will want to see that EPS figure continue to increase. 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 Yueyang Xingchang Petro-Chemical's Profit Performance

In conclusion, Yueyang Xingchang Petro-Chemical has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. Considering all this we'd argue Yueyang Xingchang Petro-Chemical's profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For instance, we've identified 3 warning signs for Yueyang Xingchang Petro-Chemical (1 can't be ignored) you should be familiar with.

Our examination of Yueyang Xingchang Petro-Chemical 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 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 that insiders are buying 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.