Why Chuang Yi Biotech's (GTSM:6566) Earnings Are Weaker Than They Seem

After announcing healthy earnings, Chuang Yi Biotech co., ltd.'s (GTSM:6566) stock rose over the last week. While the headline numbers were strong, we found some underlying problems once we started looking at what drove earnings.

Check out our latest analysis for Chuang Yi Biotech

Examining Cashflow Against Chuang Yi Biotech's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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. 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 December 2020, Chuang Yi Biotech recorded an accrual ratio of 0.41. That means it didn't generate anywhere near enough free cash flow to match its profit. Statistically speaking, that's a real negative for future earnings. In fact, it had free cash flow of NT$41m in the last year, which was a lot less than its statutory profit of NT$69.5m. Notably, Chuang Yi Biotech had negative free cash flow last year, so the NT$41m it produced this year was a welcome improvement. 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. One positive for Chuang Yi Biotech 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 Chuang Yi Biotech.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Chuang Yi Biotech issued 26% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out Chuang Yi Biotech's historical EPS growth by clicking on this link.

A Look At The Impact Of Chuang Yi Biotech's Dilution on Its Earnings Per Share (EPS).

Unfortunately, we don't have any visibility into its profits three years back, because we lack the data. 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. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. Therefore, one can observe that the dilution is having a fairly profound effect on shareholder returns.

In the long term, if Chuang Yi Biotech'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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by NT$2.6m, in the last year, probably goes some way to explain why its accrual ratio was so weak. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. We can see that Chuang Yi Biotech's positive unusual items were quite significant relative to its profit in the year 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 Chuang Yi Biotech's Profit Performance

In conclusion, Chuang Yi Biotech's 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 Chuang Yi Biotech'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, we've found that Chuang Yi Biotech has 4 warning signs (2 shouldn't be ignored!) that deserve your attention before going any further with your analysis.

Our examination of Chuang Yi Biotech 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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