After announcing healthy earnings, Lvji Technology Holdings Inc.'s (HKG:1745) stock rose over the last week. While the headline numbers were strong, we found some underlying problems once we started looking at what drove earnings.

A Closer Look At Lvji Technology Holdings' Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. 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 June 2024, Lvji Technology Holdings recorded an accrual ratio of 0.40. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of CN¥146.0m, a look at free cash flow indicates it actually burnt through CN¥112m in the last year. We also note that Lvji Technology Holdings' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥112m. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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 Lvji Technology Holdings.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Lvji Technology Holdings issued 7.1% more new shares 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 Lvji Technology Holdings' EPS by clicking here.

A Look At The Impact Of Lvji Technology Holdings' Dilution On Its Earnings Per Share (EPS)

Three years ago, Lvji Technology Holdings lost money. The good news is that profit was up 133% in the last twelve months. On the other hand, earnings per share are only up 116% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So Lvji Technology Holdings shareholders will want to see that EPS figure continue to increase. 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 Lvji Technology Holdings' Profit Performance

In conclusion, Lvji Technology Holdings has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. For the reasons mentioned above, we think that a perfunctory glance at Lvji Technology Holdings' statutory profits might make it look better than it really is on an underlying level. If you want to do dive deeper into Lvji Technology Holdings, you'd also look into what risks it is currently facing. Be aware that Lvji Technology Holdings is showing 3 warning signs in our investment analysis and 1 of those doesn't sit too well with us...

Our examination of Lvji Technology Holdings 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. 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. 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.