Strong earnings weren't enough to please Shanghai MicroPort Endovascular MedTech Co., Ltd.'s (SHSE:688016) shareholders over the last week. We did some analysis and believe that they might be concerned about some weak underlying factors.

A Closer Look At Shanghai MicroPort Endovascular MedTech's 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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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.

Shanghai MicroPort Endovascular MedTech has an accrual ratio of 0.23 for the year to September 2024. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In fact, it had free cash flow of CN¥390m in the last year, which was a lot less than its statutory profit of CN¥657.3m. At this point we should mention that Shanghai MicroPort Endovascular MedTech did manage to increase its free cash flow in the last twelve months Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

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.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Shanghai MicroPort Endovascular MedTech issued 14% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of Shanghai MicroPort Endovascular MedTech's EPS by clicking here.

A Look At The Impact Of Shanghai MicroPort Endovascular MedTech's Dilution On Its Earnings Per Share (EPS)

As you can see above, Shanghai MicroPort Endovascular MedTech has been growing its net income over the last few years, with an annualized gain of 118% over three years. In comparison, earnings per share only gained 95% over the same period. And at a glance the 48% gain in profit over the last year impresses. On the other hand, earnings per share are only up 33% in that time. And so, you can see quite clearly that dilution is influencing shareholder earnings.

In the long term, earnings per share growth should beget share price growth. So it will certainly be a positive for shareholders if Shanghai MicroPort Endovascular MedTech can grow EPS persistently. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

Given the accrual ratio, it's not overly surprising that Shanghai MicroPort Endovascular MedTech's profit was boosted by unusual items worth CN¥62m in the last twelve months. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Shanghai MicroPort Endovascular MedTech's Profit Performance

In conclusion, Shanghai MicroPort Endovascular MedTech's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. Considering all this we'd argue Shanghai MicroPort Endovascular MedTech'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 Shanghai MicroPort Endovascular MedTech at this point in time. To help with this, we've discovered 4 warning signs (1 shouldn't be ignored!) that you ought to be aware of before buying any shares in Shanghai MicroPort Endovascular MedTech.

Our examination of Shanghai MicroPort Endovascular MedTech 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 are plenty of other ways to inform your opinion of a company. 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 with high insider ownership.

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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.