Why Hankook Cosmetics' (KRX:123690) Shaky Earnings Are Just The Beginning Of Its Problems

A lackluster earnings announcement from Hankook Cosmetics Co., Ltd. (KRX:123690) last week didn't sink the stock price. Our analysis suggests that along with soft profit numbers, investors should be aware of some other underlying weaknesses in the numbers.

Check out our latest analysis for Hankook Cosmetics

A Closer Look At Hankook Cosmetics' 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). 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. While having an accrual ratio above zero is of little concern, we do think it's worth noting when a company has a relatively high accrual ratio. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Hankook Cosmetics has an accrual ratio of 0.23 for the year to September 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. In the last twelve months it actually had negative free cash flow, with an outflow of ₩1.1b despite its profit of ₩2.41b, mentioned above. It's worth noting that Hankook Cosmetics generated positive FCF of ₩7.0b a year ago, so at least they've done it 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 Hankook Cosmetics' 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. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

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

The Impact Of Unusual Items On Profit

Unfortunately (in the short term) Hankook Cosmetics saw its profit reduced by unusual items worth ₩244m. In the case where this was a non-cash charge it would have made it easier to have high cash conversion, so it's surprising that the accrual ratio tells a different story. 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. If Hankook Cosmetics doesn't see those unusual expenses repeat, then all else being equal we'd expect its profit to increase over the coming year.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Hankook Cosmetics profited from a tax benefit which contributed ₩255m to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! 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.

Our Take On Hankook Cosmetics' Profit Performance

Summing up, Hankook Cosmetics' unusual items suggest that its statutory earnings were temporarily depressed, while its tax benefit is having the opposite effect, and its accrual ratio indicates a lack of free cash flow relative to profit. Based on these factors, we think that Hankook Cosmetics' statutory profits probably make it seem better than it is on an underlying level. So while earnings quality is important, it's equally important to consider the risks facing Hankook Cosmetics at this point in time. Case in point: We've spotted 3 warning signs for Hankook Cosmetics you should be mindful of and 1 of these makes us a bit uncomfortable.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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.