Shareholders didn't appear too concerned by Anhui Xinbo Aluminum Co., Ltd.'s (SZSE:003038) weak earnings. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

Zooming In On Anhui Xinbo Aluminum's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. 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 September 2024, Anhui Xinbo Aluminum had an accrual ratio of 0.28. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. Even though it reported a profit of CN¥227.0m, a look at free cash flow indicates it actually burnt through CN¥1.4b 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¥1.4b, this year, indicates high risk. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

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. In fact, Anhui Xinbo Aluminum increased the number of shares on issue by 20% over the last twelve months by issuing new shares. That means its earnings are split among 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. You can see a chart of Anhui Xinbo Aluminum's EPS by clicking here.

A Look At The Impact Of Anhui Xinbo Aluminum's Dilution On Its Earnings Per Share (EPS)

Anhui Xinbo Aluminum has improved its profit over the last three years, with an annualized gain of 105% in that time. In comparison, earnings per share only gained 38% over the same period. Net income was down 16% over the last twelve months. But the EPS result was even worse, with the company recording a decline of 28%. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if Anhui Xinbo Aluminum's earnings per share can increase, then the share price should too. 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.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by CN¥37m, 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's as you'd expect, given these boosts are described as 'unusual'. If Anhui Xinbo Aluminum 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 Xinbo Aluminum's Profit Performance

In conclusion, Anhui Xinbo Aluminum's weak accrual ratio suggested its statutory earnings have been inflated by the unusual items. Meanwhile, the new shares issued mean that shareholders now own less of the company, unless they tipped in more cash themselves. For all the reasons mentioned above, we think that, at a glance, Anhui Xinbo Aluminum's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. To help with this, we've discovered 5 warning signs (2 make us uncomfortable!) that you ought to be aware of before buying any shares in Anhui Xinbo Aluminum.

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 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.