Statutory Profit Doesn't Reflect How Good INITECH's (KOSDAQ:053350) Earnings Are

INITECH Co., Ltd's (KOSDAQ:053350) robust earnings report didn't manage to move the market for its stock. Our analysis suggests that this might be because shareholders have noticed some concerning underlying factors.

See our latest analysis for INITECH

Examining Cashflow Against INITECH'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. 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. 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 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".

For the year to December 2020, INITECH had an accrual ratio of -0.38. That indicates that its free cash flow quite significantly exceeded its statutory profit. Indeed, in the last twelve months it reported free cash flow of ₩19b, well over the ₩1.48b it reported in profit. INITECH's free cash flow actually declined over the last year, which is disappointing, like non-biodegradable balloons. Having said that, there is more to the story. 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 INITECH.

The Impact Of Unusual Items On Profit

Surprisingly, given INITECH's accrual ratio implied strong cash conversion, its paper profit was actually boosted by ₩1.0b in unusual items. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. And that's as you'd expect, given these boosts are described as 'unusual'. We can see that INITECH's positive unusual items were quite significant relative to its profit in the year to December 2020. All else being equal, this would likely have the effect of making the statutory profit a poor guide to underlying earnings power.

Our Take On INITECH's Profit Performance

INITECH's profits got a boost from unusual items, which indicates they might not be sustained and yet its accrual ratio still indicated solid cash conversion, which is promising. Given the contrasting considerations, we don't have a strong view as to whether INITECH'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 INITECH at this point in time. For example, INITECH has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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 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 that insiders are buying to be useful.

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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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