Last week's profit announcement from Chuan Holdings Limited (HKG:1420) was underwhelming for investors, despite headline numbers being robust. Our analysis uncovered some concerning factors that we believe the market might be paying attention to.

Zooming In On Chuan Holdings' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to December 2023, Chuan Holdings recorded an accrual ratio of -0.20. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of S$16m, well over the S$3.25m it reported in profit. Given that Chuan Holdings had negative free cash flow in the prior corresponding period, the trailing twelve month resul of S$16m would seem to be a step in the right direction. Having said that, there is more to consider. 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 Chuan Holdings.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Chuan Holdings expanded the number of shares on issue by 22% over the last year. As a result, its net income is now split between a greater number of shares. 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. Check out Chuan Holdings' historical EPS growth by clicking on this link.

How Is Dilution Impacting Chuan Holdings' Earnings Per Share (EPS)?

Chuan Holdings was losing money three years ago. On the bright side, in the last twelve months it grew profit by 88%. On the other hand, earnings per share are only up 88% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

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 Chuan Holdings 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.

The Impact Of Unusual Items On Profit

While the accrual ratio might bode well, we also note that Chuan Holdings' profit was boosted by unusual items worth S$2.4m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. We can see that Chuan Holdings' 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 Chuan Holdings' Profit Performance

Summing up, Chuan Holdings' accrual ratio suggests that its statutory earnings are well matched by cash flow while its unusual items boosted the profit in a way that might not be repeated. Meanwhile, the dilution was a negative for shareholders. After taking into account all the aforementioned observations we think that Chuan Holdings' profits probably give a generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Chuan Holdings at this point in time. When we did our research, we found 3 warning signs for Chuan Holdings (1 doesn't sit too well with us!) that we believe deserve your full attention.

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 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.