Solid profit numbers didn't seem to be enough to please Yueyang Xingchang Petro-Chemical Co., Ltd.'s (SZSE:000819) shareholders. Our analysis has found some concerning factors which weaken the profit's foundation.

Examining Cashflow Against Yueyang Xingchang Petro-Chemical's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Yueyang Xingchang Petro-Chemical has an accrual ratio of 0.58 for the year to December 2023. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥101.1m, a look at free cash flow indicates it actually burnt through CN¥652m 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 CN¥652m, 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 Yueyang Xingchang Petro-Chemical.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Yueyang Xingchang Petro-Chemical issued 21% 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. You can see a chart of Yueyang Xingchang Petro-Chemical's EPS by clicking here.

A Look At The Impact Of Yueyang Xingchang Petro-Chemical's Dilution On Its Earnings Per Share (EPS)

As you can see above, Yueyang Xingchang Petro-Chemical has been growing its net income over the last few years, with an annualized gain of 272% over three years. And at a glance the 26% gain in profit over the last year impresses. On the other hand, earnings per share are only up 27% in that time. Therefore, the dilution is having a noteworthy influence on shareholder returns.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Yueyang Xingchang Petro-Chemical can grow EPS persistently. 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 Yueyang Xingchang Petro-Chemical's Profit Performance

In conclusion, Yueyang Xingchang Petro-Chemical has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. Considering all this we'd argue Yueyang Xingchang Petro-Chemical's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Yueyang Xingchang Petro-Chemical at this point in time. For example, Yueyang Xingchang Petro-Chemical has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying to be useful.

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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.