There Are Some Reasons To Suggest That Nippon Koshuha SteelLtd's (TSE:5476) Earnings Are A Poor Reflection Of Profitability

Investors appear disappointed with Nippon Koshuha Steel Co.,Ltd.'s (TSE:5476) recent earnings, despite the decent statutory profit number. Our analysis has found some underlying factors which may be cause for concern.

See our latest analysis for Nippon Koshuha SteelLtd

Zooming In On Nippon Koshuha SteelLtd'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. This ratio tells us how much of a company's profit is not backed by free cashflow.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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".

Over the twelve months to March 2024, Nippon Koshuha SteelLtd recorded an accrual ratio of 0.40. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of JP¥6.61b, a look at free cash flow indicates it actually burnt through JP¥3.0b in the last year. We also note that Nippon Koshuha SteelLtd's free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of JP¥3.0b. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Nippon Koshuha SteelLtd.

The Impact Of Unusual Items On Profit

Given the accrual ratio, it's not overly surprising that Nippon Koshuha SteelLtd's profit was boosted by unusual items worth JP¥9.8b in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. 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. Nippon Koshuha SteelLtd had a rather significant contribution from unusual items relative to its profit to March 2024. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On Nippon Koshuha SteelLtd's Profit Performance

Summing up, Nippon Koshuha SteelLtd received a nice boost to profit from unusual items, but could not match its paper profit with free cash flow. On reflection, the above-mentioned factors give us the strong impression that Nippon Koshuha SteelLtd'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. For example, we've found that Nippon Koshuha SteelLtd has 2 warning signs (1 is concerning!) that deserve your attention before going any further with your analysis.

Our examination of Nippon Koshuha SteelLtd 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. 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.

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.