Why Sumiken Mitsui RoadLtd's (TSE:1776) Shaky Earnings Are Just The Beginning Of Its Problems

Investors weren't pleased with the recent soft earnings report from Sumiken Mitsui Road Co.,Ltd. (TSE:1776). We did some digging and believe that things are better than they seem due to some encouraging factors.

View our latest analysis for Sumiken Mitsui RoadLtd

Examining Cashflow Against Sumiken Mitsui RoadLtd'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. 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.

Sumiken Mitsui RoadLtd has an accrual ratio of 0.51 for the year to September 2024. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of JP¥384.0m, a look at free cash flow indicates it actually burnt through JP¥2.1b in the last year. It's worth noting that Sumiken Mitsui RoadLtd generated positive FCF of JP¥1.3b a year ago, so at least they've done it in the past. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part. The good news for shareholders is that Sumiken Mitsui RoadLtd's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. 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 Sumiken Mitsui RoadLtd.

How Do Unusual Items Influence Profit?

Sumiken Mitsui RoadLtd's profit suffered from unusual items, which reduced profit by JP¥132m in the last twelve months. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. 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. If Sumiken Mitsui RoadLtd doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Sumiken Mitsui RoadLtd's Profit Performance

In conclusion, Sumiken Mitsui RoadLtd's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, we think it's very unlikely that Sumiken Mitsui RoadLtd's statutory profits make it seem much weaker than it is. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. For example, Sumiken Mitsui RoadLtd has 5 warning signs (and 3 which shouldn't be ignored) we think you should know about.

Our examination of Sumiken Mitsui RoadLtd has focussed on certain factors that can make its earnings look better than they are. But there are plenty of other ways to inform your opinion of a company. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.