Even though Suzhou Xianglou New Material Co., Ltd. (SZSE:301160) posted strong earnings recently, the stock hasn't reacted in a large way. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.

A Closer Look At Suzhou Xianglou New Material'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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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, Suzhou Xianglou New Material had an accrual ratio of 0.22. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of CN¥32m, in contrast to the aforementioned profit of CN¥200.7m. We also note that Suzhou Xianglou New Material's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥32m. 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.

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. In fact, Suzhou Xianglou New Material increased the number of shares on issue by 6.0% over the last twelve months by issuing new shares. As a result, its net income is now split between a greater number of shares. 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 Suzhou Xianglou New Material's historical EPS growth by clicking on this link.

A Look At The Impact Of Suzhou Xianglou New Material's Dilution On Its Earnings Per Share (EPS)

As you can see above, Suzhou Xianglou New Material has been growing its net income over the last few years, with an annualized gain of 194% over three years. But EPS was only up 120% per year, in the exact same period. And the 42% profit boost in the last year certainly seems impressive at first glance. But in comparison, EPS only increased by 28% over the same period. 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 Suzhou Xianglou New Material shareholders will want to see that EPS figure continue to increase. 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.

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by CN¥18m, in the last year, probably goes some way to explain why its accrual ratio was so weak. 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. Which is hardly surprising, given the name. If Suzhou Xianglou New Material doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Suzhou Xianglou New Material's Profit Performance

Suzhou Xianglou New Material didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. Considering all this we'd argue Suzhou Xianglou New Material's profits probably give an overly generous impression of its sustainable level of profitability. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. To help with this, we've discovered 3 warning signs (1 is a bit unpleasant!) that you ought to be aware of before buying any shares in Suzhou Xianglou New Material.

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 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. 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 that insiders are buying 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.