Anhui Zhongyuan New Materials Co., Ltd.'s (SHSE:603527) weak earnings were disregarded by the market. While shares were up, we believe there are some factors in the earnings report that might cause investors some concerns.

A Closer Look At Anhui Zhongyuan New Materials' Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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 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. 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 June 2024, Anhui Zhongyuan New Materials had an accrual ratio of 0.40. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of CN¥113.9m, a look at free cash flow indicates it actually burnt through CN¥800m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of CN¥800m, this year, indicates high risk. However, that's not the end of the story. 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 Anhui Zhongyuan New Materials.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. In fact, Anhui Zhongyuan New Materials increased the number of shares on issue by 30% over the last twelve months by issuing new shares. That means its earnings are split among 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. Check out Anhui Zhongyuan New Materials' historical EPS growth by clicking on this link.

A Look At The Impact Of Anhui Zhongyuan New Materials' Dilution On Its Earnings Per Share (EPS)

As you can see above, Anhui Zhongyuan New Materials has been growing its net income over the last few years, with an annualized gain of 24% over three years. But on the other hand, earnings per share actually fell by 3.4% per year. Net profit actually dropped by 13% in the last year. But the EPS result was even worse, with the company recording a decline of 30%. So you can see that the dilution has had a fairly significant impact on shareholders.

If Anhui Zhongyuan New Materials' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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 Anhui Zhongyuan New Materials' profit was boosted by unusual items worth CN¥29m in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. If Anhui Zhongyuan New Materials 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 Anhui Zhongyuan New Materials' Profit Performance

Anhui Zhongyuan New Materials didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. On reflection, the above-mentioned factors give us the strong impression that Anhui Zhongyuan New Materials'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you want to do dive deeper into Anhui Zhongyuan New Materials, you'd also look into what risks it is currently facing. To help with this, we've discovered 3 warning signs (1 shouldn't be ignored!) that you ought to be aware of before buying any shares in Anhui Zhongyuan New Materials.

Our examination of Anhui Zhongyuan New Materials 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. 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 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.