Shareholders Can Be Confident That Environmental Control CenterLtd's (TSE:4657) Earnings Are High Quality

Even though Environmental Control Center Co.,Ltd. (TSE:4657 ) posted strong earnings, investors appeared to be underwhelmed. We did some digging and actually think they are being unnecessarily pessimistic.

View our latest analysis for Environmental Control CenterLtd

Examining Cashflow Against Environmental Control CenterLtd'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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

For the year to December 2024, Environmental Control CenterLtd had an accrual ratio of -0.15. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of JP¥738m, well over the JP¥170.0m it reported in profit. Environmental Control CenterLtd shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Environmental Control CenterLtd.

Our Take On Environmental Control CenterLtd's Profit Performance

Environmental Control CenterLtd's accrual ratio is solid, and indicates strong free cash flow, as we discussed, above. Because of this, we think Environmental Control CenterLtd's earnings potential is at least as good as it seems, and maybe even better! Furthermore, it has done a great job growing EPS over the last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, Environmental Control CenterLtd has 3 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of Environmental Control CenterLtd's profit. 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.