We Think Shareholders Should Be Aware Of Some Factors Beyond Jia Yao Holdings' (HKG:1626) Profit

After announcing healthy earnings, Jia Yao Holdings Limited's (HKG:1626) stock rose over the last week. However, we think that shareholders should be aware of some other factors beyond the profit numbers.

Check out our latest analysis for Jia Yao Holdings

A Closer Look At Jia Yao Holdings' 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. 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. 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 June 2023, Jia Yao Holdings recorded an accrual ratio of 0.47. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥70m despite its profit of CN¥26.1m, mentioned above. We saw that FCF was CN¥60m a year ago though, so Jia Yao Holdings has at least been able to generate positive FCF in the past. Having said that, there is more to consider. 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. The good news for shareholders is that Jia Yao Holdings' 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Jia Yao Holdings.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Jia Yao Holdings increased the number of shares on issue by 100% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. 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 Jia Yao Holdings' historical EPS growth by clicking on this link.

A Look At The Impact Of Jia Yao Holdings' Dilution On Its Earnings Per Share (EPS)

We don't have any data on the company's profits from three years ago. And even focusing only on the last twelve months, we don't have a meaningful growth rate because it made a loss a year ago, too. 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). And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Jia Yao Holdings' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. 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.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥5.2m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. If Jia Yao Holdings doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Jia Yao Holdings' Profit Performance

In conclusion, Jia Yao Holdings' weak accrual ratio suggested its statutory earnings have been inflated by the 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 Jia Yao Holdings'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about Jia Yao Holdings as a business, it's important to be aware of any risks it's facing. To that end, you should learn about the 4 warning signs we've spotted with Jia Yao Holdings (including 3 which don't sit too well with us).

Our examination of Jia Yao Holdings 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.