Investors were disappointed with ECS Botanics Holdings Ltd's (ASX:ECS) earnings, despite the strong profit numbers. Our analysis uncovered some concerning factors that we believe the market might be paying attention to.

See our latest analysis for ECS Botanics Holdings

Examining Cashflow Against ECS Botanics Holdings' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

ECS Botanics Holdings has an accrual ratio of 0.26 for the year to June 2024. Unfortunately, that means its free cash flow fell significantly short of its reported profits. In the last twelve months it actually had negative free cash flow, with an outflow of AU$3.9m despite its profit of AU$1.92m, mentioned above. We also note that ECS Botanics Holdings' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of AU$3.9m. 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 ECS Botanics Holdings.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, ECS Botanics Holdings issued 16% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. 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 ECS Botanics Holdings' EPS by clicking here.

How Is Dilution Impacting ECS Botanics Holdings' Earnings Per Share (EPS)?

Three years ago, ECS Botanics Holdings lost money. The good news is that profit was up 290% in the last twelve months. On the other hand, earnings per share are only up 270% over the same period. Therefore, the dilution is having a noteworthy influence on shareholder returns.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if ECS Botanics Holdings can grow EPS persistently. 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 ECS Botanics Holdings' Profit Performance

As it turns out, ECS Botanics Holdings couldn't match its profit with cashflow and its dilution means that earnings per share growth is lagging net income growth. For the reasons mentioned above, we think that a perfunctory glance at ECS Botanics Holdings' statutory profits might make it look better than it really is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing ECS Botanics Holdings at this point in time. For example, we've found that ECS Botanics Holdings has 4 warning signs (1 can't be ignored!) that deserve your attention before going any further with your analysis.

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 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.