Aehr Test Systems' (NASDAQ:AEHR) Earnings Might Not Be As Promising As They Seem

Aehr Test Systems, Inc.'s (NASDAQ:AEHR) stock performed strongly after the recent earnings report. Investors should be cautious however, as there some causes of concern deeper in the numbers.

View our latest analysis for Aehr Test Systems

A Closer Look At Aehr Test Systems' 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.

As a result, a negative accrual ratio is a positive for the company, and a positive accrual ratio is a negative. 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. Notably, there is some academic evidence that suggests that a high accrual ratio is a bad sign for near-term profits, generally speaking.

Aehr Test Systems has an accrual ratio of 0.52 for the year to August 2024. Statistically speaking, that's a real negative for future earnings. To wit, the company did not generate one whit of free cashflow in that time. Over the last year it actually had negative free cash flow of US$427k, in contrast to the aforementioned profit of US$29.1m. It's worth noting that Aehr Test Systems generated positive FCF of US$6.9m a year ago, so at least they've done it in the past. 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.

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.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Aehr Test Systems profited from a tax benefit which contributed US$21m to profit. This is meaningful because companies usually pay tax rather than receive tax benefits. The receipt of a tax benefit is obviously a good thing, on its own. 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 Aehr Test Systems' Profit Performance

Aehr Test Systems' accrual ratio indicates weak cashflow relative to earnings, which perhaps arises in part from the tax benefit it received this year. On top of that, the unsustainable nature of tax benefits mean that there's a chance profit may be lower next year, certainly in the absence of strong growth. On reflection, the above-mentioned factors give us the strong impression that Aehr Test Systems'underlying earnings power is not as good as it might seem, based on the statutory profit numbers. With this in mind, we wouldn't consider investing in a stock unless we had a thorough understanding of the risks. Every company has risks, and we've spotted 3 warning signs for Aehr Test Systems (of which 1 makes us a bit uncomfortable!) you should know about.

Our examination of Aehr Test Systems 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.