We Think Nippon Information Development's (TYO:2349) Statutory Profit Might Understate Its Earnings Potential

Statistically speaking, it is less risky to invest in profitable companies than in unprofitable ones. Having said that, sometimes statutory profit levels are not a good guide to ongoing profitability, because some short term one-off factor has impacted profit levels. Today we'll focus on whether this year's statutory profits are a good guide to understanding Nippon Information Development (TYO:2349).

It's good to see that over the last twelve months Nippon Information Development made a profit of JP¥1.32b on revenue of JP¥18.1b. The chart below shows that revenue and profit hav both been pretty flat over the last three years.

View our latest analysis for Nippon Information Development

Of course, it is only sensible to look beyond the statutory profits and question how well those numbers represent the sustainable earnings power of the business. So today we'll look at what Nippon Information Development's cashflow and unusual items tell us about the quality of its earnings. Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Nippon Information Development.

A Closer Look At Nippon Information Development'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

For the year to September 2020, Nippon Information Development had an accrual ratio of -0.13. Therefore, its statutory earnings were quite a lot less than its free cashflow. In fact, it had free cash flow of JP¥1.9b in the last year, which was a lot more than its statutory profit of JP¥1.32b. Nippon Information Development's free cash flow improved over the last year, which is generally good to see. Having said that, there is more to the story. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

How Do Unusual Items Influence Profit?

Nippon Information Development's profit was reduced by unusual items worth JP¥251m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. In a scenario where those unusual items included non-cash charges, we'd expect to see a strong accrual ratio, which is exactly what has happened in this case. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And that's hardly a surprise given these line items are considered unusual. If Nippon Information Development doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

Our Take On Nippon Information Development's Profit Performance

In conclusion, both Nippon Information Development's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative. Looking at all these factors, we'd say that Nippon Information Development's underlying earnings power is at least as good as the statutory numbers would make it seem. While earnings are important, another area to consider is the balance sheet. If you're interested we have a graphic representation of Nippon Information Development's balance sheet.

Our examination of Nippon Information Development has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. 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 that insiders are buying to be useful.

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This article by Simply Wall St is general in nature. 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.
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