The market shrugged off JAKKS Pacific, Inc.'s (NASDAQ:JAKK) weak earnings report. Despite the market responding positively, we think that there are several concerning factors that investors should be aware of.

A Closer Look At JAKKS Pacific's Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. That's because some academic studies have suggested that high accruals ratios tend to lead to lower profit or less profit growth.

JAKKS Pacific has an accrual ratio of 0.48 for the year to September 2024. Statistically speaking, that's a real negative for future earnings. And indeed, during the period the company didn't produce any free cash flow whatsoever. In the last twelve months it actually had negative free cash flow, with an outflow of US$47m despite its profit of US$33.1m, mentioned above. It's worth noting that JAKKS Pacific generated positive FCF of US$90m a year ago, so at least they've done it in the past. Unfortunately for shareholders, the company has also been issuing new shares, diluting their share of future earnings. One positive for JAKKS Pacific shareholders is that it's accrual ratio was significantly better last year, providing reason to believe that it may return to stronger cash conversion in the future. Shareholders should look for improved cashflow relative to profit in the current year, if that is indeed the case.

That might leave you wondering what analysts are forecasting in terms of future profitability. Luckily, you can click here to see an interactive graph depicting future profitability, based on their estimates.

To understand the value of a company's earnings growth, it is imperative to consider any dilution of shareholders' interests. As it happens, JAKKS Pacific issued 9.1% more new shares over the last year. As a result, its net income is now split between a greater number of shares. To celebrate net income while ignoring dilution is like rejoicing because you have a single slice of a larger pizza, but ignoring the fact that the pizza is now cut into many more slices. You can see a chart of JAKKS Pacific's EPS by clicking here.

How Is Dilution Impacting JAKKS Pacific's Earnings Per Share (EPS)?

JAKKS Pacific was losing money three years ago. And even focusing only on the last twelve months, we see profit is down 61%. Sadly, earnings per share fell further, down a full 64% in that time. So you can see that the dilution has had a bit of an impact on shareholders.

In the long term, if JAKKS Pacific's earnings per share can increase, then the share price should too. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For that reason, you could say that EPS is more important that net income in the long run, assuming the goal is to assess whether a company's share price might grow.

Our Take On JAKKS Pacific's Profit Performance

In conclusion, JAKKS Pacific has weak cashflow relative to earnings, which indicates lower quality earnings, and the dilution means that shareholders now own a smaller proportion of the company (assuming they maintained the same number of shares). Considering all this we'd argue JAKKS Pacific's 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 JAKKS Pacific at this point in time. Our analysis shows 3 warning signs for JAKKS Pacific (1 doesn't sit too well with us!) and we strongly recommend you look at these before investing.

Our examination of JAKKS Pacific 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. Some people consider a high return on equity to be a good sign of a quality business. So you may wish to see this free collection of companies boasting high return on equity, or this list of stocks with high insider ownership.

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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.