Shareholders Shouldn’t Be Too Comfortable With Hwang Chang General Contractor's (TWSE:2543) Strong Earnings

Investors were disappointed with Hwang Chang General Contractor Co., Ltd's (TWSE:2543) recent earnings release. We did some digging and found some underlying numbers that are worrying.

Check out our latest analysis for Hwang Chang General Contractor

A Closer Look At Hwang Chang General Contractor'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. While it's not a problem to have a positive accrual ratio, indicating a certain level of non-cash profits, a high accrual ratio is arguably a bad thing, because it indicates paper profits are not matched by cash flow. 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 September 2024, Hwang Chang General Contractor recorded an accrual ratio of 0.63. 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 NT$1.6b despite its profit of NT$1.56b, mentioned above. We saw that FCF was NT$2.4b a year ago though, so Hwang Chang General Contractor has at least been able to generate positive FCF in the past. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings. One positive for Hwang Chang General Contractor 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. 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 Hwang Chang General Contractor.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Hwang Chang General Contractor issued 22% more new shares over the last year. 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 Hwang Chang General Contractor's historical EPS growth by clicking on this link.

How Is Dilution Impacting Hwang Chang General Contractor's Earnings Per Share (EPS)?

Hwang Chang General Contractor has improved its profit over the last three years, with an annualized gain of 2,586% in that time. But EPS was only up 2,461% per year, in the exact same period. And the 388% profit boost in the last year certainly seems impressive at first glance. But in comparison, EPS only increased by 366% over the same period. Therefore, the dilution is having a noteworthy influence on shareholder returns.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Hwang Chang General Contractor can grow EPS persistently. 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.

Our Take On Hwang Chang General Contractor's Profit Performance

In conclusion, Hwang Chang General Contractor 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 Hwang Chang General Contractor's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Hwang Chang General Contractor at this point in time. Every company has risks, and we've spotted 3 warning signs for Hwang Chang General Contractor (of which 2 are concerning!) you should know about.

Our examination of Hwang Chang General Contractor 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. Some people consider a high return on equity to be a good sign of a quality business. 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.