Chin Hsin Environ Engineering's (TWSE:6951) Performance Raises Some Questions

Even though Chin Hsin Environ Engineering Co., Ltd. (TWSE:6951) posted strong earnings recently, the stock hasn't reacted in a large way. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

View our latest analysis for Chin Hsin Environ Engineering

Examining Cashflow Against Chin Hsin Environ Engineering's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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'.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Chin Hsin Environ Engineering has an accrual ratio of 0.63 for the year to December 2024. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of NT$70m, in contrast to the aforementioned profit of NT$210.7m. It's worth noting that Chin Hsin Environ Engineering generated positive FCF of NT$74m 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 Chin Hsin Environ Engineering.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Chin Hsin Environ Engineering issued 15% more new shares 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 Chin Hsin Environ Engineering's EPS by clicking here.

How Is Dilution Impacting Chin Hsin Environ Engineering's Earnings Per Share (EPS)?

As you can see above, Chin Hsin Environ Engineering has been growing its net income over the last few years, with an annualized gain of 508% over three years. In comparison, earnings per share only gained 39% over the same period. And at a glance the 102% gain in profit over the last year impresses. On the other hand, earnings per share are only up 86% in that time. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, earnings per share growth should beget share price growth. So Chin Hsin Environ Engineering 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 Chin Hsin Environ Engineering's Profit Performance

As it turns out, Chin Hsin Environ Engineering couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. Considering all this we'd argue Chin Hsin Environ Engineering'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 Chin Hsin Environ Engineering at this point in time. To that end, you should learn about the 2 warning signs we've spotted with Chin Hsin Environ Engineering (including 1 which makes us a bit uncomfortable).

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 is always more to discover if you are capable of focussing your mind on minutiae. 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.