Solid Earnings May Not Tell The Whole Story For Chemtros (KOSDAQ:220260)

The market for Chemtros Co., Ltd.'s (KOSDAQ:220260) stock was strong after it released a healthy earnings report last week. While the profit numbers were good, our analysis has found some concerning factors that shareholders should be aware of.

See our latest analysis for Chemtros

Examining Cashflow Against Chemtros' 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.

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 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".

Chemtros has an accrual ratio of 0.25 for the year to March 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit. Even though it reported a profit of ₩4.45b, a look at free cash flow indicates it actually burnt through ₩13b in the last year. It's worth noting that Chemtros generated positive FCF of ₩4.5b a year ago, so at least they've done it in the past. Importantly, we note an unusual tax situation, which we discuss below, has impacted the accruals ratio. This would certainly have contributed to the weak cash conversion. The good news for shareholders is that Chemtros' 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 Chemtros.

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that Chemtros received a tax benefit of ₩1.7b. It's always a bit noteworthy when a company is paid by the tax man, rather than paying the tax man. Of course, prima facie it's great to receive a tax benefit. However, our data indicates that tax benefits can temporarily boost statutory profit in the year it is booked, but subsequently profit may fall back. In the likely event the tax benefit is not repeated, we'd expect to see its statutory profit levels drop, at least in the absence of strong growth. 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 Chemtros' Profit Performance

Chemtros' accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. If the tax benefit is not repeated, then profit would drop next year, all else being equal. Considering all this we'd argue Chemtros' profits probably give an overly generous impression of its sustainable level of profitability. So while earnings quality is important, it's equally important to consider the risks facing Chemtros at this point in time. For example, we've discovered 1 warning sign that you should run your eye over to get a better picture of Chemtros.

Our examination of Chemtros 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 is always more to discover if you are capable of focussing your mind on minutiae. 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. 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.