Shareholders Shouldn’t Be Too Comfortable With Aehr Test Systems' (NASDAQ:AEHR) Strong Earnings

Despite posting strong earnings, Aehr Test Systems' (NASDAQ:AEHR) stock didn't move much over the last week. We decided to have a deeper look, and we believe that investors might be worried about several concerning factors that we found.

See our latest analysis for Aehr Test Systems

Examining Cashflow Against Aehr Test Systems' Earnings

Many investors haven't heard of the accrual ratio from cashflow, but it is actually a useful measure of how well a company's profit is backed up by free cash flow (FCF) during a given period. 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.

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

For the year to May 2022, Aehr Test Systems had an accrual ratio of 0.57. Ergo, its free cash flow is significantly weaker than its profit. Statistically speaking, that's a real negative for future earnings. To wit, it produced free cash flow of US$1.1m during the period, falling well short of its reported profit of US$9.45m. Given that Aehr Test Systems had negative free cash flow in the prior corresponding period, the trailing twelve month resul of US$1.1m would seem to be a step in the right direction. Having said that, there is more to consider. We can look at how unusual items in the profit and loss statement impacted its accrual ratio, as well as explore how dilution is impacting shareholders negatively.

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.

In order to understand the potential for per share returns, it is essential to consider how much a company is diluting shareholders. In fact, Aehr Test Systems increased the number of shares on issue by 13% over the last twelve months by issuing new shares. Therefore, each share now receives a smaller portion of profit. Per share metrics like EPS help us understand how much actual shareholders are benefitting from the company's profits, while the net income level gives us a better view of the company's absolute size. You can see a chart of Aehr Test Systems' EPS by clicking here.

A Look At The Impact Of Aehr Test Systems' Dilution On Its Earnings Per Share (EPS)

Three years ago, Aehr Test Systems lost money. Zooming in to the last year, we still can't talk about growth rates coherently, since it made a loss last year. What we do know is that while it's great to see a profit over the last twelve months, that profit would have been better, on a per share basis, if the company hadn't needed to issue shares. And so, you can see quite clearly that dilution is influencing shareholder earnings.

If Aehr Test Systems' EPS can grow over time then that drastically improves the chances of the share price moving in the same direction. But on the other hand, we'd be far less excited to learn profit (but not EPS) was improving. For the ordinary retail shareholder, EPS is a great measure to check your hypothetical "share" of the company's profit.

How Do Unusual Items Influence Profit?

The fact that the company had unusual items boosting profit by US$1.7m, in the last year, probably goes some way to explain why its accrual ratio was so weak. While we like to see profit increases, we tend to be a little more cautious when unusual items have made a big contribution. We ran the numbers on most publicly listed companies worldwide, and it's very common for unusual items to be once-off in nature. Which is hardly surprising, given the name. Assuming those unusual items don't show up again in the current year, we'd thus expect profit to be weaker next year (in the absence of business growth, that is).

Our Take On Aehr Test Systems' Profit Performance

Aehr Test Systems didn't back up its earnings with free cashflow, but this isn't too surprising given profits were inflated by unusual items. The dilution means the results are weaker when viewed from a per-share perspective. For all the reasons mentioned above, we think that, at a glance, Aehr Test Systems' statutory profits could be considered to be low quality, because they are likely to give investors an overly positive impression of the company. Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. To help with this, we've discovered 4 warning signs (1 is a bit unpleasant!) that you ought to be aware of before buying any shares in Aehr Test Systems.

In this article we've looked at a number of factors that can impair the utility of profit numbers, and we've come away cautious. 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 that insiders are buying.

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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.