NK's (KRX:085310) Strong Earnings Are Of Good Quality

Despite posting some strong earnings, the market for NK Co., Ltd.'s (KRX:085310) stock hasn't moved much. We did some digging, and we found some concerning factors in the details.

See our latest analysis for NK

A Closer Look At NK'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. The ratio shows us how much a company's profit exceeds its FCF.

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.

For the year to December 2023, NK had an accrual ratio of 0.66. That means it didn't generate anywhere near enough free cash flow to match its profit. As a general rule, that bodes poorly for future profitability. Indeed, in the last twelve months it reported free cash flow of ₩9.8b, which is significantly less than its profit of ₩59.4b. Given that NK had negative free cash flow in the prior corresponding period, the trailing twelve month resul of ₩9.8b would seem to be a step in the right direction. However, that's not all there is to consider. The accrual ratio is reflecting the impact of unusual items on statutory profit, at least in part.

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

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) NK saw its profit reduced by unusual items worth ₩2.0b. If this was a non-cash charge, it would have made the accrual ratio better, if cashflow had stayed strong, so it's not great to see in combination with an uninspiring accrual ratio. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And that's hardly a surprise given these line items are considered unusual. NK took a rather significant hit from unusual items in the year to December 2023. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

Our Take On NK's Profit Performance

In conclusion, NK's accrual ratio suggests that its statutory earnings are not backed by cash flow, even though unusual items weighed on profit. Given the contrasting considerations, we don't have a strong view as to whether NK's profits are an apt reflection of its underlying potential for profit. So while earnings quality is important, it's equally important to consider the risks facing NK at this point in time. For instance, we've identified 2 warning signs for NK (1 doesn't sit too well with us) you should be familiar with.

In this article we've looked at a number of factors that can impair the utility of profit numbers, as a guide to a business. But there are plenty of other ways to inform your opinion of a company. 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 that insiders are buying 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.