The subdued stock price reaction suggests that Olympic Circuit Technology Co., Ltd's (SHSE:603920) strong earnings didn't offer any surprises. Investors are probably missing some underlying factors which are encouraging for the future of the company.

A Closer Look At Olympic Circuit Technology'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. The ratio shows us how much a company's profit exceeds its FCF.

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

For the year to December 2023, Olympic Circuit Technology had an accrual ratio of -0.24. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of CN¥1.2b, well over the CN¥495.5m it reported in profit. Notably, Olympic Circuit Technology had negative free cash flow last year, so the CN¥1.2b 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. In fact, Olympic Circuit Technology increased the number of shares on issue by 24% over the last twelve months by issuing new shares. 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. Check out Olympic Circuit Technology's historical EPS growth by clicking on this link.

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

As you can see above, Olympic Circuit Technology has been growing its net income over the last few years, with an annualized gain of 63% over three years. And over the last 12 months, the company grew its profit by 14%. But in comparison, EPS only increased by 14% over the same period. So you can see that the dilution has had a fairly significant impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Olympic Circuit Technology can grow EPS persistently. 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.

Our Take On Olympic Circuit Technology's Profit Performance

In conclusion, Olympic Circuit Technology has strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share growth is weaker than its profit growth. Based on these factors, we think that Olympic Circuit Technology's profits are a reasonably conservative guide to its underlying profitability. If you'd like to know more about Olympic Circuit Technology as a business, it's important to be aware of any risks it's facing. At Simply Wall St, we found 2 warning signs for Olympic Circuit Technology and we think they deserve your attention.

Our examination of Olympic Circuit Technology has focussed on certain factors that can make its earnings look better than they are. 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.

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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.