Some Investors May Be Willing To Look Past E-Guardian's (TSE:6050) Soft Earnings

E-Guardian Inc.'s (TSE:6050) stock was strong despite it releasing a soft earnings report last week. However, we think the company is showing some signs that things are more promising than they seem.

View our latest analysis for E-Guardian

Zooming In On E-Guardian'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. To get the accrual ratio we first subtract FCF from profit for a period, and then divide that number by the average operating assets for the period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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.

E-Guardian has an accrual ratio of -0.21 for the year to March 2024. That implies it has very good cash conversion, and that its earnings in the last year actually significantly understate its free cash flow. Indeed, in the last twelve months it reported free cash flow of JP¥1.5b, well over the JP¥1.11b it reported in profit. E-Guardian shareholders are no doubt pleased that free cash flow improved over the last twelve months. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

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.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, E-Guardian issued 15% more new shares over the last year. Therefore, each share now receives a smaller portion of profit. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of E-Guardian's EPS by clicking here.

A Look At The Impact Of E-Guardian's Dilution On Its Earnings Per Share (EPS)

E-Guardian has improved its profit over the last three years, with an annualized gain of 12% in that time. Net income was down 19% over the last twelve months. Unfortunately for shareholders, though, the earnings per share result was even worse, declining 24%. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if E-Guardian's earnings per share can increase, then the share price should too. However, if its profit increases while its earnings per share stay flat (or even fall) then shareholders might not see much benefit. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

How Do Unusual Items Influence Profit?

E-Guardian's profit was reduced by unusual items worth JP¥181m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. It's never great to see unusual items costing the company profits, but on the upside, things might improve sooner rather than later. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. If E-Guardian 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 E-Guardian's Profit Performance

Summing up, E-Guardian's accrual ratio and its unusual items suggest that its statutory earnings were temporarily depressed (and could bounce back), while the dilution is a negative for shareholders. Looking at all these factors, we'd say that E-Guardian's underlying earnings power is at least as good as the statutory numbers would make it seem. 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. While conducting our analysis, we found that E-Guardian has 2 warning signs and it would be unwise to ignore them.

Our examination of E-Guardian has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. But there are plenty of other ways to inform your opinion of a company. For example, many people consider a high return on equity as an indication of favorable business economics, while others like to 'follow the money' and search out stocks that insiders are buying. 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.