System Integrator's (TSE:3826) Profits May Be Overstating Its True Earnings Potential

Shareholders didn't seem to be thrilled with System Integrator Corp.'s (TSE:3826) recent earnings report, despite healthy profit numbers. Our analysis has found some concerning factors which weaken the profit's foundation.

View our latest analysis for System Integrator

A Closer Look At System Integrator'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. 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".

System Integrator has an accrual ratio of 1.30 for the year to August 2024. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Even though it reported a profit of JP¥813.0m, a look at free cash flow indicates it actually burnt through JP¥287m in the last year. It's worth noting that System Integrator generated positive FCF of JP¥326m a year ago, so at least they've done it in the past. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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

The Impact Of Unusual Items On Profit

The fact that the company had unusual items boosting profit by JP¥868m, 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 analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. Which is hardly surprising, given the name. We can see that System Integrator's positive unusual items were quite significant relative to its profit in the year to August 2024. As a result, we can surmise that the unusual items are making its statutory profit significantly stronger than it would otherwise be.

Our Take On System Integrator's Profit Performance

System Integrator had a weak accrual ratio, but its profit did receive a boost from unusual items. For all the reasons mentioned above, we think that, at a glance, System Integrator's statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. For example, we've found that System Integrator has 3 warning signs (1 is a bit unpleasant!) that deserve your attention before going any further with your analysis.

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 are plenty of other ways to inform your opinion of a company. 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.