Deswell Industries' (NASDAQ:DSWL) Profits Appear To Have Quality Issues

The market for Deswell Industries, Inc.'s (NASDAQ:DSWL) stock was strong after it released a healthy earnings report last week. Despite this, our analysis suggests that there are some factors weakening the foundations of those good profit numbers.

See our latest analysis for Deswell Industries

Examining Cashflow Against Deswell Industries' 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 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. 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 2024, Deswell Industries had an accrual ratio of -0.13. That indicates that its free cash flow was a fair bit more than its statutory profit. In fact, it had free cash flow of US$13m in the last year, which was a lot more than its statutory profit of US$7.71m. Deswell Industries shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, that's not all there is to consider. We can see that unusual items have impacted its statutory profit, and therefore the accrual ratio.

Note: we always recommend investors check balance sheet strength. Click here to be taken to our balance sheet analysis of Deswell Industries.

How Do Unusual Items Influence Profit?

While the accrual ratio might bode well, we also note that Deswell Industries' profit was boosted by unusual items worth US$952k in the last twelve months. While it's always nice to have higher profit, a large contribution from unusual items sometimes dampens our enthusiasm. When we crunched the numbers on thousands of publicly listed companies, we found that a boost from unusual items in a given year is often not repeated the next year. Which is hardly surprising, given the name. If Deswell Industries doesn't see that contribution repeat, then all else being equal we'd expect its profit to drop over the current year.

Our Take On Deswell Industries' Profit Performance

In conclusion, Deswell Industries' accrual ratio suggests its statutory earnings are of good quality, but on the other hand the profits were boosted by unusual items. Having considered these factors, we don't think Deswell Industries' statutory profits give an overly harsh view of the business. In light of this, if you'd like to do more analysis on the company, it's vital to be informed of the risks involved. Case in point: We've spotted 2 warning signs for Deswell Industries you should be aware of.

Our examination of Deswell Industries has focussed on certain factors that can make its earnings look better than they are. But there is always more to discover if you are capable of focussing your mind on minutiae. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com