Concerns Surrounding Beijing Kingee Culture Development's (SZSE:002721) Performance

The market for Beijing Kingee Culture Development Co., Ltd.'s (SZSE:002721) stock was strong after it released a healthy earnings report last week. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

Check out our latest analysis for Beijing Kingee Culture Development

A Closer Look At Beijing Kingee Culture Development's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Beijing Kingee Culture Development has an accrual ratio of 0.39 for the year to December 2023. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥665.2m, a look at free cash flow indicates it actually burnt through CN¥14m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥14m, this year, indicates high risk. 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. One positive for Beijing Kingee Culture Development shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. 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 Beijing Kingee Culture Development.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Beijing Kingee Culture Development issued 180% more new shares 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. Check out Beijing Kingee Culture Development's historical EPS growth by clicking on this link.

A Look At The Impact Of Beijing Kingee Culture Development's Dilution On Its Earnings Per Share (EPS)

Three years ago, Beijing Kingee Culture Development lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. 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). Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

In the long term, if Beijing Kingee Culture Development'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.

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Beijing Kingee Culture Development saw its profit reduced by unusual items worth CN¥43m. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. 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. If Beijing Kingee Culture Development doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Beijing Kingee Culture Development's Profit Performance

In conclusion, Beijing Kingee Culture Development'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. On top of that, the dilution means that shareholders now own less of the company. Considering all this we'd argue Beijing Kingee Culture Development'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 example, we've discovered 2 warning signs that you should run your eye over to get a better picture of Beijing Kingee Culture Development.

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. 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.