Shareholders Will Be Pleased With The Quality of DIGITAL HEARTS HOLDINGS' (TSE:3676) Earnings

DIGITAL HEARTS HOLDINGS Co., Ltd.'s (TSE:3676) earnings announcement last week was disappointing for investors, despite the decent profit numbers. We have done some analysis and have found some comforting factors beneath the profit numbers.

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A Closer Look At DIGITAL HEARTS HOLDINGS' 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. 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".

For the year to March 2025, DIGITAL HEARTS HOLDINGS had an accrual ratio of -0.22. Therefore, its statutory earnings were very significantly less than its free cashflow. Indeed, in the last twelve months it reported free cash flow of JP¥2.4b, well over the JP¥629.0m it reported in profit. DIGITAL HEARTS HOLDINGS' free cash flow improved over the last year, which is generally good to see. 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.

Check out our latest analysis for DIGITAL HEARTS HOLDINGS

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.

The Impact Of Unusual Items On Profit

DIGITAL HEARTS HOLDINGS' profit was reduced by unusual items worth JP¥633m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. When we analysed the vast majority of listed companies worldwide, we found that significant unusual items are often not repeated. And, after all, that's exactly what the accounting terminology implies. Assuming those unusual expenses don't come up again, we'd therefore expect DIGITAL HEARTS HOLDINGS to produce a higher profit next year, all else being equal.

Our Take On DIGITAL HEARTS HOLDINGS' Profit Performance

Considering both DIGITAL HEARTS HOLDINGS' accrual ratio and its unusual items, we think its statutory earnings are unlikely to exaggerate the company's underlying earnings power. Based on these factors, we think DIGITAL HEARTS HOLDINGS' underlying earnings potential is as good as, or probably even better, than the statutory profit makes it seem! With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Case in point: We've spotted 1 warning sign for DIGITAL HEARTS HOLDINGS you should be aware of.

Our examination of DIGITAL HEARTS HOLDINGS has focussed on certain factors that can make its earnings look better than they are. And it has passed with flying colours. 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. 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.