Baowu Magnesium Technology Co., Ltd. (SZSE:002182) announced strong profits, but the stock was stagnant. We did some digging, and we found some concerning factors in the details.

A Closer Look At Baowu Magnesium Technology's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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 June 2024, Baowu Magnesium Technology had an accrual ratio of 0.29. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. In the last twelve months it actually had negative free cash flow, with an outflow of CN¥2.4b despite its profit of CN¥304.9m, mentioned above. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥2.4b, this year, indicates high risk. Unfortunately for shareholders, the company has also been issuing new shares, diluting 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. As it happens, Baowu Magnesium Technology issued 9.6% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Baowu Magnesium Technology's EPS by clicking here.

A Look At The Impact Of Baowu Magnesium Technology's Dilution On Its Earnings Per Share (EPS)

As you can see above, Baowu Magnesium Technology has been growing its net income over the last few years, with an annualized gain of 5.5% over three years. In contrast, earnings per share were actually down by 2.4% per year, in the exact same period. And at a glance the 33% gain in profit over the last year impresses. But in comparison, EPS only increased by 23% 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 it will certainly be a positive for shareholders if Baowu Magnesium Technology 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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Baowu Magnesium Technology's Profit Performance

In conclusion, Baowu Magnesium Technology 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 Baowu Magnesium Technology's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Baowu Magnesium Technology as a business, it's important to be aware of any risks it's facing. Be aware that Baowu Magnesium Technology is showing 4 warning signs in our investment analysis and 2 of those can't be ignored...

Our examination of Baowu Magnesium Technology 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 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. 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 with significant insider holdings 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.

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