FLECT's (TSE:4414) Promising Earnings May Rest On Soft Foundations

Last week's profit announcement from FLECT Co., Ltd. (TSE:4414) was underwhelming for investors, despite headline numbers being robust. We did some digging and found some worrying underlying problems.

See our latest analysis for FLECT

Zooming In On FLECT's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

Therefore, it's actually considered a good thing when a company has a negative accrual ratio, but a bad thing if its accrual ratio is positive. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

FLECT has an accrual ratio of 0.49 for the year to September 2024. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. Even though it reported a profit of JP¥532.0m, a look at free cash flow indicates it actually burnt through JP¥74m in the last year. We saw that FCF was JP¥199m a year ago though, so FLECT has at least been able to generate positive FCF in the past.

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.

Our Take On FLECT's Profit Performance

As we have made quite clear, we're a bit worried that FLECT didn't back up the last year's profit with free cashflow. For this reason, we think that FLECT's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. But on the bright side, its earnings per share have grown at an extremely impressive rate over the last three years. 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. If you'd like to know more about FLECT as a business, it's important to be aware of any risks it's facing. To help with this, we've discovered 3 warning signs (1 is a bit unpleasant!) that you ought to be aware of before buying any shares in FLECT.

This note has only looked at a single factor that sheds light on the nature of FLECT's profit. 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. 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.