Earnings Troubles May Signal Larger Issues for Japan Ecosystem (TSE:9249) Shareholders

A lackluster earnings announcement from Japan Ecosystem Co., Ltd. (TSE:9249) last week didn't sink the stock price. However, we believe that investors should be aware of some underlying factors which may be of concern.

See our latest analysis for Japan Ecosystem

A Closer Look At Japan Ecosystem'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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Over the twelve months to September 2024, Japan Ecosystem recorded an accrual ratio of 0.36. 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¥622.0m, a look at free cash flow indicates it actually burnt through JP¥1.3b in the last year. It's worth noting that Japan Ecosystem generated positive FCF of JP¥291m a year ago, so at least they've done it 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 Japan Ecosystem.

One essential aspect of assessing earnings quality is to look at how much a company is diluting shareholders. As it happens, Japan Ecosystem issued 7.3% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. You can see a chart of Japan Ecosystem's EPS by clicking here.

How Is Dilution Impacting Japan Ecosystem's Earnings Per Share (EPS)?

Japan Ecosystem has improved its profit over the last three years, with an annualized gain of 8.9% in that time. But on the other hand, earnings per share actually fell by 22% per year. Net income was down 29% over the last twelve months. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 32%. So you can see that the dilution has had a bit of an impact on shareholders.

If Japan Ecosystem's EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. 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 Japan Ecosystem's Profit Performance

In conclusion, Japan Ecosystem has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). For the reasons mentioned above, we think that a perfunctory glance at Japan Ecosystem's statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Japan Ecosystem as a business, it's important to be aware of any risks it's facing. For example, Japan Ecosystem has 4 warning signs (and 1 which shouldn't be ignored) we think you should know about.

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 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.