Nova SystemLtd's (TSE:5257) Shareholders Have More To Worry About Than Only Soft Earnings

The market wasn't impressed with the soft earnings from Nova System Co.,Ltd. (TSE:5257) recently. We did some further digging and think they have a few more reasons to be concerned beyond the statutory profit.

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Zooming In On Nova SystemLtd's Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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 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.

Nova SystemLtd has an accrual ratio of 0.26 for the year to June 2025. Unfortunately, that means its free cash flow fell significantly short of its reported profits. Even though it reported a profit of JP¥318.0m, a look at free cash flow indicates it actually burnt through JP¥260m in the last year. It's worth noting that Nova SystemLtd generated positive FCF of JP¥234m a year ago, so at least they've done it in the past.

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

Our Take On Nova SystemLtd's Profit Performance

Nova SystemLtd's accrual ratio for the last twelve months signifies cash conversion is less than ideal, which is a negative when it comes to our view of its earnings. Because of this, we think that it may be that Nova SystemLtd's statutory profits are better than its underlying earnings power. But the good news is that its EPS growth over the last three years has been very impressive. At the end of the day, it's essential to consider more than just the factors above, if you want to understand the company properly. If you want to do dive deeper into Nova SystemLtd, you'd also look into what risks it is currently facing. For example, we've found that Nova SystemLtd has 3 warning signs (1 shouldn't be ignored!) that deserve your attention before going any further with your analysis.

Today we've zoomed in on a single data point to better understand the nature of Nova SystemLtd'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.