We Think Signpost's (TSE:3996) Robust Earnings Are Conservative

Investors were underwhelmed by the solid earnings posted by Signpost Corporation (TSE:3996) recently. We did some digging and actually think they are being unnecessarily pessimistic.

See our latest analysis for Signpost

Zooming In On Signpost'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. 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 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. 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 August 2024, Signpost had an accrual ratio of -0.14. That implies it has good cash conversion, and implies that its free cash flow solidly exceeded its profit last year. To wit, it produced free cash flow of JP¥320m during the period, dwarfing its reported profit of JP¥247.0m. Notably, Signpost had negative free cash flow last year, so the JP¥320m it produced this year was a welcome improvement. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation.

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

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Signpost profited from a tax benefit which contributed JP¥53m to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. And since it previously lost money, it may well simply indicate the realisation of past tax losses. 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. So while we think it's great to receive a tax benefit, it does tend to imply an increased risk that the statutory profit overstates the sustainable earnings power of the business.

Our Take On Signpost's Profit Performance

In conclusion, Signpost has strong cashflow relative to earnings, which indicates good quality earnings, but the tax benefit means its profit wasn't as sustainable as we'd like to see. Given the contrasting considerations, we don't have a strong view as to whether Signpost's profits are an apt reflection of its underlying potential for profit. 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. Every company has risks, and we've spotted 1 warning sign for Signpost you should know about.

Our examination of Signpost has focussed on certain factors that can make its earnings look better than they are. 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 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.