SFA Engineering's (KOSDAQ:056190) Soft Earnings Don't Show The Whole Picture

Soft earnings didn't appear to concern SFA Engineering Corporation's (KOSDAQ:056190) shareholders over the last week. We did some digging, and we believe the earnings are stronger than they seem.

View our latest analysis for SFA Engineering

A Closer Look At SFA Engineering'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. In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that period. 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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Over the twelve months to December 2020, SFA Engineering recorded an accrual ratio of -0.21. 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 ₩305b, well over the ₩108.3b it reported in profit. Notably, SFA Engineering had negative free cash flow last year, so the ₩305b it produced this year was a welcome improvement. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings.

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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. As it happens, SFA Engineering issued 7.2% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To talk about net income, without noticing earnings per share, is to be distracted by the big numbers while ignoring the smaller numbers that talk to per share value. Check out SFA Engineering's historical EPS growth by clicking on this link.

A Look At The Impact Of SFA Engineering's Dilution on Its Earnings Per Share (EPS).

SFA Engineering's net profit dropped by 45% per year over the last three years. And even focusing only on the last twelve months, we see profit is down 18%. Like a sack of potatoes thrown from a delivery truck, EPS fell harder, down 19% in the same period. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if SFA Engineering'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 the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

Our Take On SFA Engineering's Profit Performance

In conclusion, SFA Engineering has a strong cashflow relative to earnings, which indicates good quality earnings, but the dilution means its earnings per share are dropping faster than its profit. Considering all the aforementioned, we'd venture that SFA Engineering's profit result is a pretty good guide to its true profitability, albeit a bit on the conservative side. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. In terms of investment risks, we've identified 2 warning signs with SFA Engineering, and understanding them should be part of your investment process.

Our examination of SFA Engineering has focussed on certain factors that can make its earnings look better than they are. 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. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks that insiders are buying.

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This article by Simply Wall St is general in nature. 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.
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