Kao's (TSE:4452) Soft Earnings Don't Show The Whole Picture

Shareholders appeared unconcerned with Kao Corporation's (TSE:4452) lackluster earnings report last week. We think that the softer headline numbers might be getting counterbalanced by some positive underlying factors.

See our latest analysis for Kao

Zooming In On Kao's Earnings

In high finance, the key ratio used to measure how well a company converts reported profits into free cash flow (FCF) is the accrual ratio (from cashflow). 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 December 2023, Kao recorded an accrual ratio of -0.11. Therefore, its statutory earnings were quite a lot less than its free cashflow. To wit, it produced free cash flow of JP¥136b during the period, dwarfing its reported profit of JP¥43.9b. Kao shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to the story. We can see that unusual items have impacted its statutory profit, and therefore the 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.

The Impact Of Unusual Items On Profit

Kao's profit was reduced by unusual items worth JP¥40b 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. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. In the twelve months to December 2023, Kao 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.

Our Take On Kao's Profit Performance

In conclusion, both Kao's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Based on these factors, we think Kao'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. For example - Kao has 3 warning signs we think you should be aware of.

Our examination of Kao 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. 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 that insiders are buying.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.