We Like Sougou ShoukenLtd's (TYO:7850) Earnings For More Than Just Statutory Profit

Sougou Shouken Co.,Ltd. (TYO:7850) announced a healthy earnings result recently, and the market rewarded it with a strong stock price reaction. According to our analysis of the report, the strong headline profit numbers are supported by strong earnings fundamentals.

View our latest analysis for Sougou ShoukenLtd

Examining Cashflow Against Sougou ShoukenLtd'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). 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. 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 January 2021, Sougou ShoukenLtd recorded an accrual ratio of -0.11. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. In fact, it had free cash flow of JP¥713m in the last year, which was a lot more than its statutory profit of JP¥179.0m. Sougou ShoukenLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

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

How Do Unusual Items Influence Profit?

Sougou ShoukenLtd's profit was reduced by unusual items worth JP¥49m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. Assuming those unusual expenses don't come up again, we'd therefore expect Sougou ShoukenLtd to produce a higher profit next year, all else being equal.

Our Take On Sougou ShoukenLtd's Profit Performance

In conclusion, both Sougou ShoukenLtd's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Sougou ShoukenLtd's earnings potential is at least as good as it seems, and maybe even better! If you'd like to know more about Sougou ShoukenLtd as a business, it's important to be aware of any risks it's facing. While conducting our analysis, we found that Sougou ShoukenLtd has 2 warning signs and it would be unwise to ignore these.

Our examination of Sougou ShoukenLtd has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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 that insiders are buying.

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This article by Simply Wall St is general in nature. 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.
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