Are Muto Seiko's (TYO:7927) Statutory Earnings A Good Reflection Of Its Earnings Potential?

Broadly speaking, profitable businesses are less risky than unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. This article will consider whether Muto Seiko's (TYO:7927) statutory profits are a good guide to its underlying earnings.

We like the fact that Muto Seiko made a profit of JP¥324.0m on its revenue of JP¥18.4b, in the last year.

View our latest analysis for Muto Seiko

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. Today, we'll discuss Muto Seiko's free cashflow relative to its earnings, and consider what that tells us about the company. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Muto Seiko.

Examining Cashflow Against Muto Seiko'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. The accrual ratio subtracts the FCF from the profit for a given period, and divides the result by the average operating assets of the company over that time. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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 having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Muto Seiko has an accrual ratio of -0.11 for the year to September 2020. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. In fact, it had free cash flow of JP¥1.6b in the last year, which was a lot more than its statutory profit of JP¥324.0m. Muto Seiko shareholders are no doubt pleased that free cash flow improved over the last twelve months.

Our Take On Muto Seiko's Profit Performance

As we discussed above, Muto Seiko has perfectly satisfactory free cash flow relative to profit. Based on this observation, we consider it likely that Muto Seiko's statutory profit actually understates its earnings potential! And one can definitely find a positive in the fact that it made a profit this year, despite losing money last year. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you want to do dive deeper into Muto Seiko, you'd also look into what risks it is currently facing. Every company has risks, and we've spotted 4 warning signs for Muto Seiko you should know about.

Today we've zoomed in on a single data point to better understand the nature of Muto Seiko's profit. But there is always more to discover if you are capable of focussing your mind on minutiae. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.

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This article by Simply Wall St is general in nature. 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.
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