Nanjing Canatal Data-Centre Environmental Tech Co., Ltd's (SHSE:603912) stock wasn't much affected by its recent lackluster earnings numbers. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

Examining Cashflow Against Nanjing Canatal Data-Centre Environmental Tech'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. 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 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.

For the year to December 2023, Nanjing Canatal Data-Centre Environmental Tech had an accrual ratio of 0.22. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of CN¥159m, in contrast to the aforementioned profit of CN¥35.4m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥159m, this year, indicates high risk. However, that's not the end of the story. 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.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Nanjing Canatal Data-Centre Environmental Tech.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Nanjing Canatal Data-Centre Environmental Tech increased the number of shares on issue by 27% over the last twelve months by issuing new shares. That means its earnings are split among 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. You can see a chart of Nanjing Canatal Data-Centre Environmental Tech's EPS by clicking here.

A Look At The Impact Of Nanjing Canatal Data-Centre Environmental Tech's Dilution On Its Earnings Per Share (EPS)

Unfortunately, Nanjing Canatal Data-Centre Environmental Tech's profit is down 69% per year over three years. Even looking at the last year, profit was still down 3.1%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 22% in the same period. So you can see that the dilution has had a fairly significant impact on shareholders.

If Nanjing Canatal Data-Centre Environmental Tech's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. 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.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥11m, 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. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that Nanjing Canatal Data-Centre Environmental Tech's positive unusual items were quite significant relative to its profit in the year to December 2023. 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 Nanjing Canatal Data-Centre Environmental Tech's Profit Performance

Nanjing Canatal Data-Centre Environmental Tech didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by 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 Nanjing Canatal Data-Centre Environmental Tech'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about Nanjing Canatal Data-Centre Environmental Tech as a business, it's important to be aware of any risks it's facing. For instance, we've identified 4 warning signs for Nanjing Canatal Data-Centre Environmental Tech (3 are significant) you should be familiar with.

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 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. 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.