A lackluster earnings announcement from Garrett Motion Inc. (NASDAQ:GTX) last week didn't sink the stock price. We think that investors are worried about some weaknesses underlying the earnings.

A Closer Look At Garrett Motion's 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. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to March 2024, Garrett Motion had an accrual ratio of -0.46. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of US$350m, well over the US$6.00m it reported in profit. Garrett Motion's free cash flow improved over the last year, which is generally good to see. Notably, the company has issued new shares, thus diluting existing shareholders and reducing 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. As it happens, Garrett Motion issued 248% more new shares over the last year. 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. Check out Garrett Motion's historical EPS growth by clicking on this link.

A Look At The Impact Of Garrett Motion's Dilution On Its Earnings Per Share (EPS)

Unfortunately, Garrett Motion's profit is down 86% per year over three years. And even focusing only on the last twelve months, we see profit is down 88%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 96% in the same period. And so, you can see quite clearly that dilution is having a rather significant impact on shareholders.

In the long term, if Garrett Motion'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.

Our Take On Garrett Motion's Profit Performance

In conclusion, Garrett Motion has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Given the contrasting considerations, we don't have a strong view as to whether Garrett Motion's profits are an apt reflection of its underlying potential for profit. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. To that end, you should learn about the 4 warning signs we've spotted with Garrett Motion (including 2 which shouldn't be ignored).

Our examination of Garrett Motion has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 that insiders are buying 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.