We Believe That Dowell Service Group's (HKG:2352) Weak Earnings Are A Good Indicator Of Underlying Profitability

Shareholders didn't appear too concerned by Dowell Service Group Co. Limited's (HKG:2352) weak earnings. Our analysis suggests that they may be missing some concerning details underlying the profit numbers.

See our latest analysis for Dowell Service Group

Examining Cashflow Against Dowell Service Group's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. 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 June 2023, Dowell Service Group recorded an accrual ratio of 0.27. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Over the last year it actually had negative free cash flow of CN¥8.6m, in contrast to the aforementioned profit of CN¥68.7m. It's worth noting that Dowell Service Group generated positive FCF of CN¥126m a year ago, so at least they've done it in the past. Unfortunately for shareholders, the company has also been issuing new shares, diluting 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 Dowell Service Group.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Dowell Service Group expanded the number of shares on issue by 100% over the last year. Therefore, each share now receives a smaller portion of profit. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Dowell Service Group's EPS by clicking here.

How Is Dilution Impacting Dowell Service Group's Earnings Per Share (EPS)?

Dowell Service Group has improved its profit over the last three years, with an annualized gain of 25% in that time. In contrast, earnings per share were actually down by 6.8% per year, in the exact same period. Net profit actually dropped by 49% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 60%. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Dowell Service Group'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.

Our Take On Dowell Service Group's Profit Performance

As it turns out, Dowell Service Group couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). For the reasons mentioned above, we think that a perfunctory glance at Dowell Service Group's statutory profits might make it look better than it really is on an underlying level. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. When we did our research, we found 3 warning signs for Dowell Service Group (2 are significant!) that we believe deserve your full attention.

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.