We Think That There Are Issues Underlying Digital Garage's (TSE:4819) Earnings

Investors were disappointed with Digital Garage, Inc.'s (TSE:4819) earnings, despite the strong profit numbers. We did some digging and found some worrying underlying problems.

See our latest analysis for Digital Garage

Zooming In On Digital Garage's Earnings

One key financial ratio used to measure how well a company converts its profit to free cash flow (FCF) is the accrual ratio. 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. This ratio tells us how much of a company's profit is not backed by free cashflow.

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

Digital Garage has an accrual ratio of 0.33 for the year to March 2024. We can therefore deduce that its free cash flow fell well short of covering its statutory profit, suggesting we might want to think twice before putting a lot of weight on the latter. Even though it reported a profit of JP¥5.81b, a look at free cash flow indicates it actually burnt through JP¥14b in the last year. We saw that FCF was JP¥11b a year ago though, so Digital Garage has at least been able to generate positive FCF in the past. One positive for Digital Garage 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.

Our Take On Digital Garage's Profit Performance

As we have made quite clear, we're a bit worried that Digital Garage didn't back up the last year's profit with free cashflow. For this reason, we think that Digital Garage's statutory profits may be a bad guide to its underlying earnings power, and might give investors an overly positive impression of the company. The good news is that it earned a profit in the last twelve months, despite its previous loss. Of course, we've only just scratched the surface when it comes to analysing its earnings; one could also consider margins, forecast growth, and return on investment, among other factors. So while earnings quality is important, it's equally important to consider the risks facing Digital Garage at this point in time. For example, Digital Garage has 2 warning signs (and 1 which can't be ignored) we think you should know about.

This note has only looked at a single factor that sheds light on the nature of Digital Garage's profit. But there are plenty of other ways to inform your opinion of a company. 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 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.