Shareholders didn't seem to be thrilled with Creative China Holdings Limited's (HKG:8368) recent earnings report, despite healthy profit numbers. Our analysis has found some concerning factors which weaken the profit's foundation.

Zooming In On Creative China Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Creative China Holdings has an accrual ratio of 0.45 for the year to June 2024. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of CN¥51m, in contrast to the aforementioned profit of CN¥53.0m. We saw that FCF was CN¥11m a year ago though, so Creative China Holdings has at least been able to generate positive FCF in the past. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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 Creative China Holdings.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Creative China Holdings issued 35% more new shares over the last year. That means its earnings are split among 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 Creative China Holdings' historical EPS growth by clicking on this link.

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

Creative China Holdings has improved its profit over the last three years, with an annualized gain of 221% in that time. In comparison, earnings per share only gained 43% over the same period. And in the last year the company managed to bump profit up by 10%. But that's starkly different from the 18% drop in earnings per share. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

If Creative China Holdings' 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.

Our Take On Creative China Holdings' Profit Performance

In conclusion, Creative China Holdings has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). For the reasons mentioned above, we think that a perfunctory glance at Creative China Holdings' statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Creative China Holdings as a business, it's important to be aware of any risks it's facing. To that end, you should learn about the 3 warning signs we've spotted with Creative China Holdings (including 1 which shouldn't be ignored).

Our examination of Creative China Holdings 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. 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 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.