Statutory Profit Doesn't Reflect How Good Watts' (TSE:2735) Earnings Are

Even though Watts Co., Ltd. (TSE:2735 ) posted strong earnings, investors appeared to be underwhelmed. We have done some analysis and have found some comforting factors beneath the profit numbers.

Check out our latest analysis for Watts

A Closer Look At Watts' 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). 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.

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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

For the year to August 2024, Watts had an accrual ratio of -0.32. That indicates that its free cash flow quite significantly exceeded its statutory profit. To wit, it produced free cash flow of JP¥3.4b during the period, dwarfing its reported profit of JP¥904.0m. Given that Watts had negative free cash flow in the prior corresponding period, the trailing twelve month resul of JP¥3.4b would seem to be a step in the right direction.

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

Our Take On Watts' Profit Performance

As we discussed above, Watts' accrual ratio indicates strong conversion of profit to free cash flow, which is a positive for the company. Based on this observation, we consider it possible that Watts' statutory profit actually understates its earnings potential! Furthermore, it has done a great job growing EPS over the last year. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. You'd be interested to know, that we found 2 warning signs for Watts and you'll want to know about these.

Today we've zoomed in on a single data point to better understand the nature of Watts' 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. While it might take a little research on your behalf, you may find this free collection of companies boasting high return on equity, or this list of stocks with significant insider holdings to be useful.

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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.