We Believe SM ENTERTAINMENT JAPANLtd's (TSE:4772) Earnings Are A Poor Guide For Its Profitability

Despite posting strong earnings, SM ENTERTAINMENT JAPAN Co.,Ltd.'s (TSE:4772) stock didn't move much over the last week. We looked deeper into the numbers and found that shareholders might be concerned with some underlying weaknesses.

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Examining Cashflow Against SM ENTERTAINMENT JAPANLtd'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. 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'.

That means a negative accrual ratio is a good thing, because it shows that the company is bringing in more free cash flow than its profit would suggest. 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. 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 June 2025, SM ENTERTAINMENT JAPANLtd recorded an accrual ratio of 0.26. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Over the last year it actually had negative free cash flow of JP¥84m, in contrast to the aforementioned profit of JP¥868.0m. We saw that FCF was JP¥257m a year ago though, so SM ENTERTAINMENT JAPANLtd has at least been able to generate positive FCF in the past. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

Check out our latest analysis for SM ENTERTAINMENT JAPANLtd

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of SM ENTERTAINMENT JAPANLtd.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by JP¥822m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that SM ENTERTAINMENT JAPANLtd's positive unusual items were quite significant relative to its profit in the year to June 2025. 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

In addition to the notable accrual ratio, we can see that SM ENTERTAINMENT JAPANLtd received a tax benefit of JP¥81m. This is meaningful because companies usually pay tax rather than receive tax benefits. Of course, prima facie it's great to receive a tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On SM ENTERTAINMENT JAPANLtd's Profit Performance

In conclusion, SM ENTERTAINMENT JAPANLtd'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. On reflection, the above-mentioned factors give us the strong impression that SM ENTERTAINMENT JAPANLtd'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. If you'd like to know more about SM ENTERTAINMENT JAPANLtd as a business, it's important to be aware of any risks it's facing. For example, SM ENTERTAINMENT JAPANLtd has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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 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 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.