Shareholders appeared unconcerned with Giga Device Semiconductor Inc.'s (SHSE:603986) lackluster earnings report last week. We did some digging, and we believe the earnings are stronger than they seem.

A Closer Look At Giga Device Semiconductor's 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). In plain english, this ratio subtracts FCF from net profit, and divides that number by the company's average operating assets over that 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. To quote a 2014 paper by Lewellen and Resutek, "firms with higher accruals tend to be less profitable in the future".

Giga Device Semiconductor has an accrual ratio of -0.17 for the year to March 2024. Therefore, its statutory earnings were very significantly less than its free cashflow. To wit, it produced free cash flow of CN¥1.3b during the period, dwarfing its reported profit of CN¥215.8m. Giga Device Semiconductor shareholders are no doubt pleased that free cash flow improved over the last twelve months. However, we can see that a recent tax benefit, along with unusual items, have impacted its statutory profit, and therefore its accrual ratio.

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.

The Impact Of Unusual Items On Profit

Giga Device Semiconductor's profit was reduced by unusual items worth CN¥296m in the last twelve months, and this helped it produce high cash conversion, as reflected by its unusual items. This is what you'd expect to see where a company has a non-cash charge reducing paper profits. While deductions due to unusual items are disappointing in the first instance, there is a silver lining. We looked at thousands of listed companies and found that unusual items are very often one-off in nature. And, after all, that's exactly what the accounting terminology implies. In the twelve months to March 2024, Giga Device Semiconductor had a big unusual items expense. As a result, we can surmise that the unusual items made its statutory profit significantly weaker than it would otherwise be.

An Unusual Tax Situation

Moving on from the accrual ratio, we note that Giga Device Semiconductor profited from a tax benefit which contributed CN¥33m 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! Of course, prima facie it's great to receive a 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. 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.

Our Take On Giga Device Semiconductor's Profit Performance

In conclusion, both Giga Device Semiconductor's accrual ratio and its unusual items suggest that its statutory earnings are probably reasonably conservative, but the presence of a tax benefits may be inflating the numbers in a way that won't persist. Based on these factors, we think Giga Device Semiconductor's earnings potential is at least as good as it seems, and maybe even better! Keep in mind, when it comes to analysing a stock it's worth noting the risks involved. While conducting our analysis, we found that Giga Device Semiconductor has 2 warning signs and it would be unwise to ignore them.

After our examination into the nature of Giga Device Semiconductor's profit, we've come away optimistic for the company. 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 that insiders are buying 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.