Does Tokuden's (TYO:3437) Statutory Profit Adequately Reflect Its Underlying Profit?

Many investors consider it preferable to invest in profitable companies over unprofitable ones, because profitability suggests a business is sustainable. However, sometimes companies receive a one-off boost (or reduction) to their profit, and it's not always clear whether statutory profits are a good guide, going forward. This article will consider whether Tokuden's (TYO:3437) statutory profits are a good guide to its underlying earnings.

It's good to see that over the last twelve months Tokuden made a profit of JP¥414.0m on revenue of JP¥9.59b. The chart below shows how it has grown revenue over the last three years, but that profit has declined.

View our latest analysis for Tokuden

Not all profits are equal, and we can learn more about the nature of a company's past profitability by diving deeper into the financial statements. Today, we'll discuss Tokuden's free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Tokuden.

Examining Cashflow Against Tokuden'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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 2020, Tokuden had an accrual ratio of -0.17. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of JP¥1.0b during the period, dwarfing its reported profit of JP¥414.0m. Given that Tokuden had negative free cash flow in the prior corresponding period, the trailing twelve month resul of JP¥1.0b would seem to be a step in the right direction.

Our Take On Tokuden's Profit Performance

As we discussed above, Tokuden's accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Because of this, we think Tokuden's underlying earnings potential is as good as, or possibly even better, than the statutory profit makes it seem! And on top of that, its earnings per share have grown at 9.4% per year over the last three years. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 1 warning sign for Tokuden you should be aware of.

Today we've zoomed in on a single data point to better understand the nature of Tokuden's profit. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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This article by Simply Wall St is general in nature. 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.
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