Impressive Earnings May Not Tell The Whole Story For Mercuries Data Systems (TWSE:2427)

Despite announcing strong earnings, Mercuries Data Systems Ltd.'s (TWSE:2427) stock was sluggish. We think that the market might be paying attention to some underlying factors that they find to be concerning.

View our latest analysis for Mercuries Data Systems

A Closer Look At Mercuries Data Systems' 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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.

For the year to September 2024, Mercuries Data Systems had an accrual ratio of 0.23. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of NT$267.4m, a look at free cash flow indicates it actually burnt through NT$795m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of NT$795m, this year, indicates high risk. 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 Mercuries Data Systems.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Mercuries Data Systems issued 6.8% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. 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 Mercuries Data Systems' historical EPS growth by clicking on this link.

A Look At The Impact Of Mercuries Data Systems' Dilution On Its Earnings Per Share (EPS)

As you can see above, Mercuries Data Systems has been growing its net income over the last few years, with an annualized gain of 134% over three years. But EPS was only up 121% per year, in the exact same period. And the 33% profit boost in the last year certainly seems impressive at first glance. But in comparison, EPS only increased by 26% over the same period. And so, you can see quite clearly that dilution is influencing shareholder earnings.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Mercuries Data Systems 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 Mercuries Data Systems' Profit Performance

As it turns out, Mercuries Data Systems 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 Mercuries Data Systems' profits probably give an overly generous impression of its sustainable level of profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 4 warning signs for Mercuries Data Systems you should be mindful of and 2 of these are potentially serious.

Our examination of Mercuries Data Systems 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 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.