Concerns Surrounding Cheer Holding's (NASDAQ:CHR) Performance

Following the solid earnings report from Cheer Holding, Inc. (NASDAQ:CHR), the market responded by bidding up the stock price. However, we think that shareholders should be cautious as we found some worrying factors underlying the profit.

See our latest analysis for Cheer Holding

Zooming In On Cheer Holding'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. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Cheer Holding has an accrual ratio of -0.12 for the year to December 2023. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of US$42m during the period, dwarfing its reported profit of US$30.5m. Given that Cheer Holding had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$42m would seem to be a step in the right direction. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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 Cheer Holding.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, Cheer Holding issued 48% 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. Check out Cheer Holding's historical EPS growth by clicking on this link.

A Look At The Impact Of Cheer Holding's Dilution On Its Earnings Per Share (EPS)

Cheer Holding's net profit dropped by 38% per year over the last three years. On the bright side, in the last twelve months it grew profit by 13%. But earnings per share are actually down 11%, over that same period. This is a great example of why it's rather imprudent to rely only on net income as a growth measure. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, if Cheer Holding's earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Cheer Holding's Profit Performance

In conclusion, Cheer Holding 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. Having considered these factors, we don't think Cheer Holding's statutory profits give an overly harsh view of the business. If you want to do dive deeper into Cheer Holding, you'd also look into what risks it is currently facing. For example - Cheer Holding has 3 warning signs we think you should be aware of.

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 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 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.