Beijing Jingcheng Machinery Electric's (HKG:187) Earnings Are Built On Soft Foundations

Shareholders were pleased with the recent earnings report from Beijing Jingcheng Machinery Electric Company Limited (HKG:187). However, we think that investors should be cautious when interpreting the profit numbers.

View our latest analysis for Beijing Jingcheng Machinery Electric

A Closer Look At Beijing Jingcheng Machinery Electric'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. 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.

Over the twelve months to December 2020, Beijing Jingcheng Machinery Electric recorded an accrual ratio of 0.23. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥53m, in contrast to the aforementioned profit of CN¥156.4m. We saw that FCF was CN¥67m a year ago though, so Beijing Jingcheng Machinery Electric has at least been able to generate positive FCF in the past. Having said that, there is more to consider. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares. The good news for shareholders is that Beijing Jingcheng Machinery Electric's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. 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 Jingcheng Machinery Electric.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Beijing Jingcheng Machinery Electric increased the number of shares on issue by 15% over the last twelve months by issuing new shares. 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 Jingcheng Machinery Electric's historical EPS growth by clicking on this link.

How Is Dilution Impacting Beijing Jingcheng Machinery Electric's Earnings Per Share? (EPS)

As it happens, we don't know how much the company made or lost three years ago, because we don't have the data. 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). So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if Beijing Jingcheng Machinery Electric'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 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?

Given the accrual ratio, it's not overly surprising that Beijing Jingcheng Machinery Electric's profit was boosted by unusual items worth CN¥264m in the last twelve months. 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. Which is hardly surprising, given the name. Beijing Jingcheng Machinery Electric had a rather significant contribution from unusual items relative to its profit to December 2020. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Beijing Jingcheng Machinery Electric's Profit Performance

Beijing Jingcheng Machinery Electric didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. On reflection, the above-mentioned factors give us the strong impression that Beijing Jingcheng Machinery Electric'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about Beijing Jingcheng Machinery Electric as a business, it's important to be aware of any risks it's facing. Every company has risks, and we've spotted 3 warning signs for Beijing Jingcheng Machinery Electric (of which 1 is a bit unpleasant!) you should know about.

Our examination of Beijing Jingcheng Machinery Electric 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. 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. 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.
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