The market rallied behind Deswell Industries, Inc.'s (NASDAQ:DSWL) stock, leading do a rise in the share price after its recent weak earnings report. While shareholders may be willing to overlook soft profit numbers, we believe that they should also be taking into account some other factors which may be cause for concern.

Examining Cashflow Against Deswell Industries' Earnings

As finance nerds would already know, the accrual ratio from cashflow is a key measure for assessing how well a company's free cash flow (FCF) matches its profit. 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. You could think of the accrual ratio from cashflow as the 'non-FCF profit ratio'.

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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Deswell Industries has an accrual ratio of 0.22 for the year to March 2026. Therefore, we know that it's free cashflow was significantly lower than its statutory profit, which is hardly a good thing. In fact, it had free cash flow of US$4.7m in the last year, which was a lot less than its statutory profit of US$10.6m. Deswell Industries' free cash flow actually declined over the last year, but it may bounce back next year, since free cash flow is often more volatile than accounting profits. However, as we will discuss below, we can see that the company's accrual ratio has been impacted by its tax situation. This would certainly have contributed to the weak cash conversion. One positive for Deswell Industries 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.

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

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Deswell Industries profited from a tax benefit which contributed US$363k to profit. This is of course a bit out of the ordinary, given it is more common for companies to be paying tax than receiving tax benefits! We're sure the company was pleased with its tax benefit. However, the devil in the detail is that these kind of benefits only impact in the year they are booked, and are often one-off in nature. Assuming the tax benefit is not repeated every year, we could see its profitability drop noticeably, all else being equal. 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 Deswell Industries' Profit Performance

This year, Deswell Industries couldn't match its profit with cashflow. If the tax benefit is not repeated, then profit would drop next year, all else being equal. For the reasons mentioned above, we think that a perfunctory glance at Deswell Industries' statutory profits might make it look better than it really is on an underlying level. If you'd like to know more about Deswell Industries as a business, it's important to be aware of any risks it's facing. To help with this, we've discovered 3 warning signs (1 doesn't sit too well with us!) that you ought to be aware of before buying any shares in Deswell Industries.

Our examination of Deswell Industries 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. 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.

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.