Shaky Earnings May Not Tell The Whole Story For Namkwang Engineering & Construction (KRX:001260)

Shareholders didn't appear too concerned by Namkwang Engineering & Construction Co., Ltd.'s (KRX:001260) weak earnings. We did some digging, and we believe that investors are missing some worrying factors underlying the profit figures.

Check out our latest analysis for Namkwang Engineering & Construction

Zooming In On Namkwang Engineering & Construction's 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). 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. 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Namkwang Engineering & Construction has an accrual ratio of 0.35 for the year to December 2023. Unfortunately, that means its free cash flow was a lot less than its statutory profit, which makes us doubt the utility of profit as a guide. Over the last year it actually had negative free cash flow of ₩25b, in contrast to the aforementioned profit of ₩5.99b. We saw that FCF was ₩26b a year ago though, so Namkwang Engineering & Construction has at least been able to generate positive FCF in the past. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio. The good news for shareholders is that Namkwang Engineering & Construction's accrual ratio was much better last year, so this year's poor reading might simply be a case of a short term mismatch between profit and FCF. As a result, some shareholders may be looking for stronger cash conversion in the current year.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Namkwang Engineering & Construction.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by ₩270m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Namkwang Engineering & Construction profited from a tax benefit which contributed ₩1.3b to profit. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. The receipt of a tax benefit is obviously a good thing, on its own. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. While we think it's good that the company has booked a tax benefit, it does mean that there's every chance the statutory profit will come in a lot higher than it would be if the income was adjusted for one-off factors.

Our Take On Namkwang Engineering & Construction's Profit Performance

In conclusion, Namkwang Engineering & Construction's weak accrual ratio suggests its statutory earnings have been inflated by the non-cash tax benefit and the boost it received from unusual items. On reflection, the above-mentioned factors give us the strong impression that Namkwang Engineering & Construction'sunderlying earnings power is not as good as it might seem, based on the statutory profit numbers. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Our analysis shows 3 warning signs for Namkwang Engineering & Construction (1 makes us a bit uncomfortable!) and we strongly recommend you look at them before investing.

Our examination of Namkwang Engineering & Construction has focussed on certain factors that can make its earnings look better than they are. And, on that basis, we are somewhat skeptical. 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. 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.