CMC's (TSE:2185) Earnings Are Of Questionable Quality

CMC Corporation (TSE:2185) just reported some strong earnings, and the market reacted accordingly with a healthy uplift in the share price. However, we think that shareholders may be missing some concerning details in the numbers.

View our latest analysis for CMC

Zooming In On CMC's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. 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. 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 September 2024, CMC had an accrual ratio of 0.31. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Over the last year it actually had negative free cash flow of JP¥209m, in contrast to the aforementioned profit of JP¥2.08b. It's worth noting that CMC generated positive FCF of JP¥2.7b a year ago, so at least they've done it in the past. One positive for CMC shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. 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 CMC.

Our Take On CMC's Profit Performance

CMC'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. Therefore, it seems possible to us that CMC's true underlying earnings power is actually less than its statutory profit. But at least holders can take some solace from the 32% per annum growth in EPS for the last three. The goal of this article has been to assess how well we can rely on the statutory earnings to reflect the company's potential, but there is plenty more to consider. If you want to do dive deeper into CMC, you'd also look into what risks it is currently facing. For example, CMC has 3 warning signs (and 2 which are significant) we think you should know about.

Today we've zoomed in on a single data point to better understand the nature of CMC'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. 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.