Microwave Chemical's (TSE:9227) Profits May Not Reveal Underlying Issues

Microwave Chemical Co., Ltd.'s (TSE:9227 ) stock didn't jump after it announced some healthy earnings. Our analysis showed that there are some concerning factors in the earnings that investors may be cautious of.

Our free stock report includes 3 warning signs investors should be aware of before investing in Microwave Chemical. Read for free now.

A Closer Look At Microwave Chemical'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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Microwave Chemical has an accrual ratio of 0.48 for the year to March 2025. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of JP¥161.0m, a look at free cash flow indicates it actually burnt through JP¥195m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of JP¥195m, this year, indicates high risk. The good news for shareholders is that Microwave Chemical'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 Microwave Chemical.

Our Take On Microwave Chemical's Profit Performance

As we discussed above, we think Microwave Chemical's earnings were not supported by free cash flow, which might concern some investors. As a result, we think it may well be the case that Microwave Chemical's underlying earnings power is lower than its statutory profit. 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 Microwave Chemical at this point in time. Be aware that Microwave Chemical is showing 3 warning signs in our investment analysis and 2 of those are potentially serious...

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

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.