We Think Solvvy's (TSE:7320) Solid Earnings Are Understated

The stock was sluggish on the back of Solvvy Inc.'s (TSE:7320) recent earnings report. Along with the solid headline numbers, we think that investors have some reasons for optimism.

See our latest analysis for Solvvy

Examining Cashflow Against Solvvy'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. 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.

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

Solvvy has an accrual ratio of -0.17 for the year to December 2024. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of JP¥1.5b, well over the JP¥1.10b it reported in profit. Solvvy shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not the end of the story. We must also consider the impact of unusual items on statutory profit (and thus the accrual ratio), as well as note the ramifications of the company issuing new shares.

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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. Solvvy expanded the number of shares on issue by 15% over the last year. As a result, its net income is now split between a greater number of shares. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. Check out Solvvy's historical EPS growth by clicking on this link.

A Look At The Impact Of Solvvy's Dilution On Its Earnings Per Share (EPS)

As you can see above, Solvvy has been growing its net income over the last few years, with an annualized gain of 100% over three years. And in the last year the company managed to bump profit up by 20%. On the other hand, earnings per share are only up 17% in that time. So you can see that the dilution has had a bit of an impact on shareholders.

Changes in the share price do tend to reflect changes in earnings per share, in the long run. So it will certainly be a positive for shareholders if Solvvy can grow EPS persistently. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

The Impact Of Unusual Items On Profit

Solvvy's profit was reduced by unusual items worth JP¥143m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect Solvvy to produce a higher profit next year, all else being equal.

Our Take On Solvvy's Profit Performance

Summing up, Solvvy's accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed (and could bounce back), while the dilution is a negative for shareholders. Looking at all these factors, we'd say that Solvvy's underlying earnings power is at least as good as the statutory numbers would make it seem. So while earnings quality is important, it's equally important to consider the risks facing Solvvy at this point in time. Every company has risks, and we've spotted 1 warning sign for Solvvy you should know about.

After our examination into the nature of Solvvy's profit, we've come away optimistic for the company. 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.