Cheer Holding, Inc. (NASDAQ:CHR) just released a solid earnings report, and the stock displayed some strength. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

Zooming In On Cheer Holding'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. 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'.

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 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to December 2023, Cheer Holding recorded an accrual ratio of -0.12. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. Indeed, in the last twelve months it reported free cash flow of US$42m, well over the US$30.5m it reported in profit. Notably, Cheer Holding had negative free cash flow last year, so the US$42m it produced this year was a welcome improvement. Unfortunately for shareholders, the company has also been issuing new shares, diluting 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 Cheer Holding.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. Cheer Holding expanded the number of shares on issue by 48% 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 Cheer Holding's historical EPS growth by clicking on this link.

A Look At The Impact Of Cheer Holding's Dilution On Its Earnings Per Share (EPS)

Unfortunately, Cheer Holding's profit is down 38% per year over three years. The good news is that profit was up 13% in the last twelve months. But EPS was far less impressive, dropping 11% in that time. This shows how dangerous it is to rely on net income alone, when measuring growth. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Cheer Holding's earnings per share can increase, then the share price should too. 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.

Our Take On Cheer Holding's Profit Performance

In conclusion, Cheer Holding has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Based on these factors, we think it's very unlikely that Cheer Holding's statutory profits make it seem much weaker than it is. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. For example, we've discovered 3 warning signs that you should run your eye over to get a better picture of Cheer Holding.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.