We Think That There Are More Issues For Baowu Magnesium Technology (SZSE:002182) Than Just Sluggish Earnings

The market rallied behind Baowu Magnesium Technology Co., Ltd.'s (SZSE:002182) stock, leading do a rise in the share price after its recent weak earnings report. While shareholders may be willing to overlook soft profit numbers, we believe that they should also be taking into account some other factors which may be cause for concern.

See our latest analysis for Baowu Magnesium Technology

Zooming In On Baowu Magnesium Technology'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). The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. 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.

Over the twelve months to March 2024, Baowu Magnesium Technology recorded an accrual ratio of 0.27. 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¥2.1b, in contrast to the aforementioned profit of CN¥316.5m. It's worth noting that Baowu Magnesium Technology generated positive FCF of CN¥110m a year ago, so at least they've done it in the past. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Baowu Magnesium Technology increased the number of shares on issue by 9.6% over the last twelve months by issuing new shares. As a result, its net income is now split between 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. Check out Baowu Magnesium Technology's historical EPS growth by clicking on this link.

How Is Dilution Impacting Baowu Magnesium Technology's Earnings Per Share (EPS)?

Baowu Magnesium Technology has improved its profit over the last three years, with an annualized gain of 13% in that time. Net profit actually dropped by 11% in the last year. But the EPS result was even worse, with the company recording a decline of 16%. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if Baowu Magnesium Technology'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 Baowu Magnesium Technology's Profit Performance

In conclusion, Baowu Magnesium Technology 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 Baowu Magnesium Technology's statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Baowu Magnesium Technology at this point in time. Be aware that Baowu Magnesium Technology is showing 4 warning signs in our investment analysis and 2 of those are concerning...

Our examination of Baowu Magnesium Technology 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. Some people consider a high return on equity to be a good sign of a quality business. 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.