Impressive Earnings May Not Tell The Whole Story For Koatsu KogyoLtd (TSE:1743)

Despite posting some strong earnings, the market for Koatsu Kogyo Co.,Ltd.'s (TSE:1743) stock hasn't moved much. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

Check out our latest analysis for Koatsu KogyoLtd

A Closer Look At Koatsu KogyoLtd'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Koatsu KogyoLtd has an accrual ratio of 0.31 for the year to March 2024. 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 JP¥547.0m, a look at free cash flow indicates it actually burnt through JP¥2.2b in the last year. It's worth noting that Koatsu KogyoLtd generated positive FCF of JP¥1.0b a year ago, so at least they've done it in the past. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio. One positive for Koatsu KogyoLtd shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Koatsu KogyoLtd.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Koatsu KogyoLtd's profit was boosted by unusual items worth JP¥46m in the last twelve months. 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, after all, that's exactly what the accounting terminology implies. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Koatsu KogyoLtd's Profit Performance

Summing up, Koatsu KogyoLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. Considering all this we'd argue Koatsu KogyoLtd's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Koatsu KogyoLtd at this point in time. For instance, we've identified 3 warning signs for Koatsu KogyoLtd (1 is a bit unpleasant) you should be familiar with.

Our examination of Koatsu KogyoLtd 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 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. 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.