Statutory Earnings May Not Be The Best Way To Understand SLD Entertainment's (TSE:3223) True Position

Even though SLD Entertainment, Inc. (TSE:3223) posted strong earnings recently, the stock hasn't reacted in a large way. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

See our latest analysis for SLD Entertainment

Examining Cashflow Against SLD Entertainment'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. 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.

Over the twelve months to February 2024, SLD Entertainment recorded an accrual ratio of 1.08. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of JP¥177.0m, a look at free cash flow indicates it actually burnt through JP¥2.0m in the last year. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of JP¥2.0m, this year, indicates high risk. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio. This would partially explain why the accrual ratio was so poor. The good news for shareholders is that SLD Entertainment'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.

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

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that SLD Entertainment received a tax benefit of JP¥49m. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. And given that it lost money last year, it seems possible that the benefit is evidence that it now expects to find value in its past tax losses. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. 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.

Our Take On SLD Entertainment's Profit Performance

SLD Entertainment's accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. On top of that, the unsustainable nature of tax benefits mean that there's a chance profit may be lower next year, certainly in the absence of strong growth. Considering all this we'd argue SLD Entertainment's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. You'd be interested to know, that we found 2 warning signs for SLD Entertainment and you'll want to know about these.

Our examination of SLD Entertainment has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. But there is always more to discover if you are capable of focussing your mind on minutiae. 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 that insiders are buying 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.