First Baking's (TSE:2215) Shareholders Should Assess Earnings With Caution

The latest earnings release from First Baking Co., Ltd. (TSE:2215 ) disappointed investors. We did some analysis and believe that they might be concerned about some weak underlying factors.

See our latest analysis for First Baking

A Closer Look At First Baking'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. The ratio shows us how much a company's profit exceeds its FCF.

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. 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".

First Baking has an accrual ratio of 0.32 for the year to December 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. To wit, it produced free cash flow of JP¥277m during the period, falling well short of its reported profit of JP¥2.06b. We note, however, that First Baking grew its free cash flow over the last year. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

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

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that First Baking's profit was boosted by unusual items worth JP¥1.2b in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And, after all, that's exactly what the accounting terminology implies. First Baking had a rather significant contribution from unusual items relative to its profit to December 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that First Baking profited from a tax benefit which contributed JP¥231m 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. 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 First Baking's Profit Performance

In conclusion, First Baking's weak accrual ratio suggests its statutory earnings have been inflated by the non-cash tax benefit and the boost it received from unusual items. For all the reasons mentioned above, we think that, at a glance, First Baking's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. If you want to do dive deeper into First Baking, you'd also look into what risks it is currently facing. Our analysis shows 3 warning signs for First Baking (1 doesn't sit too well with us!) and we strongly recommend you look at these before investing.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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. 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.