Shareholders Can Be Confident That Pacific Systems' (TSE:3847) Earnings Are High Quality

Investors were underwhelmed by the solid earnings posted by Pacific Systems Corporation (TSE:3847) recently. We did some digging and actually think they are being unnecessarily pessimistic.

View our latest analysis for Pacific Systems

Zooming In On Pacific Systems' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

Pacific Systems has an accrual ratio of -0.16 for the year to March 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. In fact, it had free cash flow of JP¥1.1b in the last year, which was a lot more than its statutory profit of JP¥580.0m. Pacific Systems shareholders are no doubt pleased that free cash flow improved over the last twelve months.

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

Our Take On Pacific Systems' Profit Performance

As we discussed above, Pacific Systems has perfectly satisfactory free cash flow relative to profit. Because of this, we think Pacific Systems' earnings potential is at least as good as it seems, and maybe even better! And on top of that, its earnings per share have grown at 48% per year 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. So if you'd like to dive deeper into this stock, it's crucial to consider any risks it's facing. When we did our research, we found 3 warning signs for Pacific Systems (1 is a bit concerning!) that we believe deserve your full attention.

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