Shunfa Hengneng (SZSE:000631) Shareholders Should Be Cautious Despite Solid Earnings

Shunfa Hengneng Corporation (SZSE:000631) posted some decent earnings, but shareholders didn't react strongly. Our analysis suggests they may be concerned about some underlying details.

Check out our latest analysis for Shunfa Hengneng

A Closer Look At Shunfa Hengneng'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to June 2024, Shunfa Hengneng had an accrual ratio of 0.44. Ergo, its free cash flow is significantly weaker than its profit. As a general rule, that bodes poorly for future profitability. In fact, it had free cash flow of CN¥3.7m in the last year, which was a lot less than its statutory profit of CN¥309.6m. Shunfa Hengneng shareholders will no doubt be hoping that its free cash flow bounces back next year, since it was down over the last twelve months. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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 Shunfa Hengneng.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Shunfa Hengneng expanded the number of shares on issue by 8.7% 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 Shunfa Hengneng's EPS by clicking here.

A Look At The Impact Of Shunfa Hengneng's Dilution On Its Earnings Per Share (EPS)

Shunfa Hengneng has improved its profit over the last three years, with an annualized gain of 94% in that time. And at a glance the 135% gain in profit over the last year impresses. On the other hand, earnings per share are only up 186% in that time. Therefore, the dilution is having a noteworthy influence on shareholder returns.

In the long term, earnings per share growth should beget share price growth. So Shunfa Hengneng shareholders will want to see that EPS figure continue to increase. 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.

Our Take On Shunfa Hengneng's Profit Performance

In conclusion, Shunfa Hengneng 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 Shunfa Hengneng's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Case in point: We've spotted 5 warning signs for Shunfa Hengneng you should be mindful of and 2 of these can't be ignored.

Our examination of Shunfa Hengneng 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. 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 with high insider ownership.

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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.