Why Kasumigaseki CapitalLtd's (TSE:3498) Healthy Earnings Aren’t As Good As They Seem

Kasumigaseki Capital Co.,Ltd.'s (TSE:3498) solid earnings report last week was underwhelming to investors. We think that they may be worried about something else, so we did some analysis and found that investors have noticed some soft numbers underlying the profit.

View our latest analysis for Kasumigaseki CapitalLtd

Examining Cashflow Against Kasumigaseki CapitalLtd'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). 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. 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. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Over the twelve months to February 2024, Kasumigaseki CapitalLtd recorded an accrual ratio of 0.80. As a general rule, that bodes poorly for future profitability. And indeed, during the period the company didn't produce any free cash flow whatsoever. Over the last year it actually had negative free cash flow of JP¥23b, in contrast to the aforementioned profit of JP¥2.53b. Coming off the back of negative free cash flow last year, we imagine some shareholders might wonder if its cash burn of JP¥23b, this year, indicates high risk. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, Kasumigaseki CapitalLtd issued 20% more new shares over the last year. That means its earnings are split among a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. Check out Kasumigaseki CapitalLtd's historical EPS growth by clicking on this link.

A Look At The Impact Of Kasumigaseki CapitalLtd's Dilution On Its Earnings Per Share (EPS)

Kasumigaseki CapitalLtd has improved its profit over the last three years, with an annualized gain of 3,615% in that time. In comparison, earnings per share only gained 2,724% over the same period. And at a glance the 48% gain in profit over the last year impresses. But in comparison, EPS only increased by 42% over the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, earnings per share growth should beget share price growth. So Kasumigaseki CapitalLtd shareholders will want to see that EPS figure continue to increase. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On Kasumigaseki CapitalLtd's Profit Performance

In conclusion, Kasumigaseki CapitalLtd has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means its earnings per share growth is weaker than its profit growth. Considering all this we'd argue Kasumigaseki CapitalLtd's profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Kasumigaseki CapitalLtd at this point in time. For example, we've found that Kasumigaseki CapitalLtd has 4 warning signs (3 are a bit unpleasant!) that deserve your attention before going any further with your analysis.

Our examination of Kasumigaseki CapitalLtd 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 are plenty of other ways to inform your opinion of a company. 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. 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.