Investors Shouldn't Be Too Comfortable With Nitchitsu's (TSE:7021) Earnings

Last week's profit announcement from Nitchitsu Co., Ltd. (TSE:7021) was underwhelming for investors, despite headline numbers being robust. We think that the market might be paying attention to some underlying factors that they find to be concerning.

See our latest analysis for Nitchitsu

A Closer Look At Nitchitsu'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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 March 2024, Nitchitsu had an accrual ratio of 0.20. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Over the last year it actually had negative free cash flow of JP¥1.4b, in contrast to the aforementioned profit of JP¥247.0m. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of JP¥1.4b, this year, indicates high risk. The good news for shareholders is that Nitchitsu'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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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

Our Take On Nitchitsu's Profit Performance

Nitchitsu's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Nitchitsu's statutory profits are better than its underlying earnings power. On the bright side, the company showed enough improvement to book a profit this year, after losing money last year. 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. So while earnings quality is important, it's equally important to consider the risks facing Nitchitsu at this point in time. For example, Nitchitsu has 4 warning signs (and 3 which make us uncomfortable) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of Nitchitsu'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. 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.