Chimney's (TSE:3178) Earnings May Just Be The Starting Point

The subdued stock price reaction suggests that Chimney Co., Ltd.'s (TSE:3178) strong earnings didn't offer any surprises. Our analysis suggests that investors might be missing some promising details.

See our latest analysis for Chimney

A Closer Look At Chimney's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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'.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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 March 2024, Chimney recorded an accrual ratio of -0.28. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. To wit, it produced free cash flow of JP¥2.3b during the period, dwarfing its reported profit of JP¥938.0m. Chimney's free cash flow improved over the last year, which is generally good to see. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

How Do Unusual Items Influence Profit?

Chimney's profit was reduced by unusual items worth JP¥706m 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. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. In the twelve months to March 2024, Chimney had a big unusual items expense. All else being equal, this would likely have the effect of making the statutory profit look worse than its underlying earnings power.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Chimney profited from a tax benefit which contributed JP¥197m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! The receipt of a tax benefit is obviously a good thing, on its own. And since it previously lost money, it may well simply indicate the realisation of past tax losses. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal.

Our Take On Chimney's Profit Performance

In conclusion, both Chimney's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the presence of a tax benefits may be inflating the numbers in a way that won't persist. Based on these factors, we think Chimney's earnings potential is at least as good as it seems, and maybe even better! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. At Simply Wall St, we found 1 warning sign for Chimney and we think they deserve your attention.

Our examination of Chimney has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.