Shanghai Ruking Technologies Co., Ltd.'s (SZSE:301525) 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.

Zooming In On Shanghai Ruking Technologies' 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). To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. The ratio shows us how much a company's profit exceeds its FCF.

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

For the year to June 2024, Shanghai Ruking Technologies had an accrual ratio of 0.40. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥194.0m, a look at free cash flow indicates it actually burnt through CN¥37m in the last year. It's worth noting that Shanghai Ruking Technologies generated positive FCF of CN¥133m a year ago, so at least they've done it in the past. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. Shanghai Ruking Technologies expanded the number of shares on issue by 33% over the last year. 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. You can see a chart of Shanghai Ruking Technologies' EPS by clicking here.

A Look At The Impact Of Shanghai Ruking Technologies' Dilution On Its Earnings Per Share (EPS)

As you can see above, Shanghai Ruking Technologies has been growing its net income over the last few years, with an annualized gain of 135% over three years. But EPS was only up 76% per year, in the exact same period. Net profit actually dropped by 18% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 35%. So you can see that the dilution has had a fairly significant impact on shareholders.

If Shanghai Ruking Technologies' 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 Shanghai Ruking Technologies' Profit Performance

In conclusion, Shanghai Ruking Technologies 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 Shanghai Ruking Technologies' statutory profits might make it look better than it really is on an underlying level. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Be aware that Shanghai Ruking Technologies is showing 3 warning signs in our investment analysis and 1 of those is concerning...

Our examination of Shanghai Ruking Technologies 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. 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.