Investors Shouldn't Be Too Comfortable With Chimney's (TSE:3178) Earnings

Chimney Co., Ltd.'s (TSE:3178) robust earnings report didn't manage to move the market for its stock. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

We've discovered 1 warning sign about Chimney. View them for free.

Examining Cashflow Against Chimney'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. 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. The ratio shows us how much a company's profit exceeds its FCF.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Chimney has an accrual ratio of 0.20 for the year to March 2025. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In fact, it had free cash flow of JP¥92m in the last year, which was a lot less than its statutory profit of JP¥1.08b. Chimney's free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. Having said that it seems that a recent tax benefit and some unusual items have impacted its profit (and this its accrual ratio). The good news for shareholders is that Chimney's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

See our latest analysis for Chimney

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

How Do Unusual Items Influence Profit?

Unfortunately (in the short term) Chimney saw its profit reduced by unusual items worth JP¥414m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. 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 2025, 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

In addition to the notable accrual ratio, we can see that Chimney received a tax benefit of JP¥432m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. 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. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Chimney's Profit Performance

In conclusion, Chimney's accrual ratio suggests that its statutory earnings are not backed by cash flow, in part due to the tax benefit it received; but the fact unusual items actually weighed on profit may create upside if those unusual items do not recur. Having considered these factors, we don't think Chimney's statutory profits give an overly harsh view of the business. 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, we've discovered 1 warning sign that you should run your eye over to get a better picture of Chimney.

Our examination of Chimney has focussed on certain factors that can make its earnings look better than they are. 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.

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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.