We Believe Zeta's (TSE:6031) Earnings Are A Poor Guide For Its Profitability

Investors were disappointed with Zeta Inc.'s (TSE:6031) recent earnings release. We did some analysis and believe that they might be concerned about some weak underlying factors.

See our latest analysis for Zeta

A Closer Look At Zeta'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. 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

For the year to December 2024, Zeta had an accrual ratio of 0.67. 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¥539.0m, a look at free cash flow indicates it actually burnt through JP¥11m in the last year. It's worth noting that Zeta generated positive FCF of JP¥112m a year ago, so at least they've done it in the past. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio. This would certainly have contributed to the weak cash conversion. One positive for Zeta shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. As a result, some shareholders may be looking for stronger cash conversion in the current year.

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

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Zeta received a tax benefit of JP¥169m. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. 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. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Zeta's Profit Performance

Zeta's accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. If the tax benefit is not repeated, then profit would drop next year, all else being equal. Considering all this we'd argue Zeta's profits probably give an overly generous impression of its sustainable level of profitability. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. Be aware that Zeta is showing 3 warning signs in our investment analysis and 1 of those is significant...

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. 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 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.