There Might Be More To Kitano Construction's (TSE:1866) Story Than Just Weak Earnings

The recent earnings release from Kitano Construction Corp. (TSE:1866 ) was disappointing to investors. We looked deeper and believe that there is even more to be worried about, beyond the soft profit numbers.

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A Closer Look At Kitano Construction's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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. The ratio shows us how much a company's profit exceeds its FCF.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. 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 March 2025, Kitano Construction had an accrual ratio of 0.45. As a general rule, that bodes poorly for future profitability. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of JP¥3.38b, a look at free cash flow indicates it actually burnt through JP¥6.9b in the last year. We saw that FCF was JP¥1.3b a year ago though, so Kitano Construction has at least been able to generate positive FCF in the past. 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 Kitano Construction.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Kitano Construction issued 6.3% more new shares over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Kitano Construction's historical EPS growth by clicking on this link.

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

As you can see above, Kitano Construction has been growing its net income over the last few years, with an annualized gain of 94% over three years. Net profit actually dropped by 13% in the last year. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 17%. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if Kitano Construction's earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. 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 Kitano Construction's Profit Performance

As it turns out, Kitano Construction couldn't match its profit with cashflow and its dilution means that shareholders own less of the company than the did before (unless they bought more shares). Considering all this we'd argue Kitano Construction's profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about Kitano Construction as a business, it's important to be aware of any risks it's facing. For instance, we've identified 2 warning signs for Kitano Construction (1 doesn't sit too well with us) you should be familiar with.

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.