Solid Earnings May Not Tell The Whole Story For KUWAZAWA Holdings (TSE:8104)

KUWAZAWA Holdings Corporation's (TSE:8104 ) stock didn't jump after it announced some healthy earnings. We think that investors might be worried about some concerning underlying factors.

See our latest analysis for KUWAZAWA Holdings

Examining Cashflow Against KUWAZAWA Holdings' 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.

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 March 2024, KUWAZAWA Holdings had an accrual ratio of 0.24. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of JP¥741.0m, a look at free cash flow indicates it actually burnt through JP¥1.8b in the last year. We saw that FCF was JP¥1.1b a year ago though, so KUWAZAWA Holdings has at least been able to generate positive FCF 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. The good news for shareholders is that KUWAZAWA Holdings' 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 KUWAZAWA Holdings.

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) KUWAZAWA Holdings saw its profit reduced by unusual items worth JP¥245m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect KUWAZAWA Holdings to produce a higher profit next year, all else being equal.

Our Take On KUWAZAWA Holdings' Profit Performance

In conclusion, KUWAZAWA Holdings' accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Based on these factors, it's hard to tell if KUWAZAWA Holdings' profits are a reasonable reflection of its underlying profitability. So while earnings quality is important, it's equally important to consider the risks facing KUWAZAWA Holdings at this point in time. When we did our research, we found 4 warning signs for KUWAZAWA Holdings (2 don't sit too well with us!) that we believe deserve your full attention.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. 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.

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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.