SeA Mechanics' (KOSDAQ:396300) Earnings Aren't As Good As They Appear

Even though SeA Mechanics Co., Ltd (KOSDAQ:396300) posted strong earnings recently, the stock hasn't reacted in a large way. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.

View our latest analysis for SeA Mechanics

Zooming In On SeA Mechanics' 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.

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. That is not intended to imply we should worry about a positive accrual ratio, but it's worth noting where the accrual ratio is rather high. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

SeA Mechanics has an accrual ratio of 0.33 for the year to March 2024. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, raising questions about how useful that profit figure really is. In the last twelve months it actually had negative free cash flow, with an outflow of ₩14b despite its profit of ₩6.93b, mentioned above. We also note that SeA Mechanics' free cash flow was actually negative last year as well, so we could understand if shareholders were bothered by its outflow of ₩14b. 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.

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

An Unusual Tax Situation

In addition to the notable accrual ratio, we can see that SeA Mechanics received a tax benefit of ₩3.0b. 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 SeA Mechanics' Profit Performance

This year, SeA Mechanics couldn't match its profit with cashflow. If the tax benefit is not repeated, then profit would drop next year, all else being equal. Considering all this we'd argue SeA Mechanics' profits probably give an overly generous impression of its sustainable level of profitability. If you'd like to know more about SeA Mechanics as a business, it's important to be aware of any risks it's facing. When we did our research, we found 2 warning signs for SeA Mechanics (1 is significant!) that we believe deserve your full attention.

Our examination of SeA Mechanics 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. 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.