Investors Can Find Comfort In Zyxel Group's (TWSE:3704) Earnings Quality

Zyxel Group Corporation's (TWSE:3704) earnings announcement last week didn't impress shareholders. However, our analysis suggests that the soft headline numbers are getting counterbalanced by some positive underlying factors.

Check out our latest analysis for Zyxel Group

Examining Cashflow Against Zyxel Group's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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.

Zyxel Group has an accrual ratio of -0.25 for the year to December 2023. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of NT$3.4b, well over the NT$1.34b it reported in profit. Notably, Zyxel Group had negative free cash flow last year, so the NT$3.4b it produced this year was a welcome improvement. Notably, the company has issued new shares, thus diluting existing shareholders and reducing their share of future earnings.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Zyxel Group expanded the number of shares on issue by 15% 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. You can see a chart of Zyxel Group's EPS by clicking here.

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

Zyxel Group has improved its profit over the last three years, with an annualized gain of 62% in that time. Net profit actually dropped by 17% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 13%. Therefore, the dilution is having a noteworthy influence on shareholder returns.

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

Our Take On Zyxel Group's Profit Performance

In conclusion, Zyxel Group has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Based on these factors, we think that Zyxel Group's profits are a reasonably conservative guide to its underlying profitability. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. You'd be interested to know, that we found 2 warning signs for Zyxel Group and you'll want to know about these.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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 that insiders are buying.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.