Investors were disappointed with Talant Optronics (Suzhou) Co., Ltd.'s (SZSE:301045) recent earnings release. We did some analysis and believe that they might be concerned about some weak underlying factors.

A Closer Look At Talant Optronics (Suzhou)'s 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. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2024, Talant Optronics (Suzhou) had an accrual ratio of 0.23. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. Even though it reported a profit of CN¥14.5m, a look at free cash flow indicates it actually burnt through CN¥137m in the last year. We also note that Talant Optronics (Suzhou)'s free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of CN¥137m. 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.

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, Talant Optronics (Suzhou) increased the number of shares on issue by 6.9% 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 Talant Optronics (Suzhou)'s historical EPS growth by clicking on this link.

A Look At The Impact Of Talant Optronics (Suzhou)'s Dilution On Its Earnings Per Share (EPS)

Unfortunately, Talant Optronics (Suzhou)'s profit is down 87% per year over three years. On the bright side, in the last twelve months it grew profit by 866%. On the other hand, earnings per share are only up 862% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So Talant Optronics (Suzhou) 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.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Talant Optronics (Suzhou)'s profit was boosted by unusual items worth CN¥2.0m in the last twelve months. We can't deny that higher profits generally leave us optimistic, but we'd prefer it if the profit were to be sustainable. 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. Talant Optronics (Suzhou) had a rather significant contribution from unusual items relative to its profit to September 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On Talant Optronics (Suzhou)'s Profit Performance

In conclusion, Talant Optronics (Suzhou)'s weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. The dilution means the results are weaker when viewed from a per-share perspective. Considering all this we'd argue Talant Optronics (Suzhou)'s profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Talant Optronics (Suzhou) as a business, it's important to be aware of any risks it's facing. Case in point: We've spotted 2 warning signs for Talant Optronics (Suzhou) you should be mindful of and 1 of them shouldn't be ignored.

Our examination of Talant Optronics (Suzhou) 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. 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.