1. Management's Statement

In the opinion of Management, the accompanying unaudited financial statements contain all adjustments (all of which are normal and recurring in nature) necessary to present fairly the financial position of Deswell Industries, Inc. (the Company) on March 31, 1998 and March 31, 1997, the results of operations for the quarters and years ended March 31, 1998 and March 31, 1997, and the cash flows for the years ended March 31, 1998 and March 31, 1997. The notes to the Consolidated Financial Statements, which are contained in Form 20-F Annual Report filed on July 15, 1997 under the Securities Exchange Act of 1934, should be read in conjunction with these Consolidated Financial Statements.

2. Inventories

3. Earnings Per Share

The basic earnings per share and diluted earnings per share are computed in accordance with the Statement of Financial Accounting Standards No.128 commencing the quarter ended December 31, 1997. The basic and diluted earnings per share for prior periods are also restated in accordance with the Statement of Financial Accounting Standards No. 128.

The basic earnings per share is computed on the income from continuing operations and net income respectively, available to common stockholders, divided by the weighted average number of common shares outstanding throughout the relevant periods.

The diluted earnings per share is computed on the income from continuing operations and net income respectively, available to common stockholders, divided by the weighted average number of common shares outstanding and the number of additional common shares that outstanding if the dilutive potential common shares had been issued throughout the relevant periods.

The weighted average number of Common Shares in 1998 and 1997 include 1,000,000 Common Shares issued in the July 1995 IPO, the Over-allotment of 150,000 Common Shares issued in August 1995 and the additional Common Shares issued upon the exercise of Stock Options, Advisor and Representatives' Warrants and Public Warrants during the years ended March 31, 1998 and March 31, 1997.

The net income for the quarters and years ended March 31, 1998 and 1997 were both from the Company's continuing operations.

4. Warrant Redemption

The Company has completed the redemption of its outstanding Common Share Purchase Warrants on February 18, 1998. 896,649 Warrants were exercised for total gross proceeds of US$4,060,027. The Warrants were issued as part of and in conjunction with Company's initial public offering of Common Shares and Common Shares Purchase Warrants that was completed in July 1995. The balance of 11,275 Warrants which were not exercised were redeemed by the Company at $0.05 per Warrant. As a result of the exercise of the Warrants, the Company issued an aggregate of 448,324 new Common Shares and has 5,479,131 Common Shares outstanding since February 18, 1998.

Results of Operations

General

The Company's revenues are derived from the manufacture and sale of (i) injection-molded plastic parts and components, (ii) electronic products and subassemblies and (iii) metallic parts and components. The Company carries out all of its manufacturing operations in southern China, where it is able to take advantage of lower overhead costs and inexpensive labor rates as compared to Hong Kong.

Quarter Ended March 31, 1998 Compared to Quarter Ended March 31, 1997

The Company's net sales for the quarter ended March 31, 1998 were $14,509,000, an increase of $1,833,000 or 14.5%, as compared to the corresponding period in 1997. The increase in sales was mainly related to additional sales of injection-molded plastic and metallic products of $2,149,000 and $838,000 respectively net of the decrease in electronic sales of $1,154,000. This represented increases of 33.5% and 206.9% and a decrease of 19.7% respectively, as compared with the net sales in the corresponding period in the prior year.

The increase in net sales from plastic operations was attributed to the continuing increase in orders from our existing customers. The substantial increase in metallic sales was a result of the Company's efforts in strengthening its metallic operation during the year though it accounted for less than 10% of overall revenue. The decrease in sales of electronic products in this quarter was mainly due to the increases in shipments in the quarter ended December 31, 1997 to meet customers seasonal requirements and to avoid the production lag period during the Lunar New Year holidays in January and February 1998. Moreover, the Company continues to generate higher volume demand from its customers this year as a result of the Company's continuous efforts to produce high quality products.

The gross profit for the quarter ended March 31, 1998 was $5,904,000, representing a gross profit margin of 40.7%. This compares with the overall gross profit and gross profit margin of $5,329,000 or 42.0% for the quarter ended March 31, 1997.

Selling, general and administrative expenses for the quarter ended March 31, 1998 were $2,531,000, amounting to 17.4% of total net sales, as compared to $2,224,000 or 17.5% of total net sales for the quarter ended March 31, 1997. The increase in selling, general and administrative expenses of $307,000 over the corresponding period was largely due to the growth in the Company's operations.

As a result of the increase in net sales, operating income was $3,373,000 for the quarter ended March 31, 1998, an increase of $268,000 or 8.6%, as compared with the corresponding quarter in the prior year.

Minority interests represent the 49% and 66.9% minority interest in the electronics and metallic subsidiaries respectively. The decrease in minority interest to $533,000 for the quarter ended March 31, 1998 from $538,000 for the corresponding quarter in the prior year reflects the fact that the electronic business generated less profit in the current period as compared to prior year.

As a result of the above factors, net income was $2,868,000 for the quarter ended March 31, 1998, an increase of $636,000 or 28.5%, as compared to the quarter ended March 31, 1997 and net income as a percentage of net sales increased slightly to 19.8% from 17.6%.

Year Ended March 31, 1998 Compared to Year Ended March 31, 1997

The Company's net sales for the year ended March 31, 1998 were $66,169,000, an increase of $21,629,000 or 48.6%, as compared to year ended March 31, 1997. The increase in sales was mainly related to additional sales of injection-molded plastic, electronic and metallic products of $7,782,000, $11,008,000 and $2,839,000 respectively, or increases of 31.4%, 59.2% and 237.6% respectively as compared with the net sales in the prior year. Revenues from the metallic operation were generated from a subsidiary acquired in October 1996. The substantial increase in sales of electronic products was mainly attributed to the increase in both OEM and sub-contract sales to its existing customers. Moreover, the Company continues to generate higher volume demands from its customers this year as a result of the Company's continuous efforts to produce high quality products.

The gross profit for the year ended March 31, 1998 was $29,923,000, representing a gross profit margin of 45.2%. This compares with the overall gross profit and gross profit margin of $19,075,000 or 42.8% for the year ended March 31, 1997. The slight increase in gross margin of 2.4% was mainly attributed to higher margins generated from the plastic assembly work this year and from the plastic tooling modification requests from an existing customer, and the higher margin generated from the increase in electronic subcontracting orders.

Selling, general and administrative expenses for the year ended March 31, 1998 were $14,067,000, amounting to 21.3% of total net sales, as compared to $7,943,000 or 17.8% of total net sales for the year ended March 31, 1997. The increase in selling, general and administrative expenses of $6,124,000 over the prior year was largely due to the growth in the Company's operations.

As a result of the increase in net sales, operating income was $15,856,000 for the year ended March 31, 1998, an increase of $4,724,000 or 42.4% as compared with the prior year.

Minority interests represent the 49% and 66.9% minority interest in the electronics and metallic subsidiaries respectively. The increase in minority interest to $3,289,000 for the year ended March 31, 1998 from $2,165,000 for the year ended March 31, 1997 reflects the fact that the electronic business generated significant profits in the current year as compared to the prior year. As the operation of metallic subsidiary is in preliminary stage, the operating results and the minority interest effects were not material in the year ended March 31, 1998.

As a result of the above factors, net income was $12,971,000 for the year ended March 31, 1998, an increase of $4,226,000 or 48.3%, as compared to the year ended March 31, 1997 and net income as a percentage of net sales remained at 19.6% for both years.

Liquidity and Capital Resources

Traditionally, the Company has relied primarily upon internally generated funds and short-term borrowings (including trade finance facilities) to finance its operations and expansion, although capital expenditure has been partly financed by long-term debt, including capital leases.

As of March 31, 1998, the Company had a working capital surplus of $35,968,000. This compares with a working capital surplus of $21,375,000 on March 31, 1997. The increase in working capital was mainly attributed to net cash generated from its operating activities and from the exercise of stock options, representatives' warrants and public warrants during the year.

The Company has generated sufficient funds from its operating activities to finance its operations and there is little need for external financing other than short-term borrowings which are used to finance accounts receivable and are generally paid with cash generated from operations. The Company has no outstanding short-term borrowings and no long-term debt as of March 31, 1998.

As of March 31, 1998, the Company had in place general banking facilities with three financial institutions aggregating approximately $12,016,000. Such facilities, which are subject to annual review, include overdrafts, letters of credit, import facilities, trust receipt financing, inward bills financing as well as fixed loans. At March 31, 1998, the Company had ( i ) unused credit facilities of $12,016,000 ( ii ) cash and cash equivalents of $21,902,000 and ( iii ) restricted cash of $2,927,000, which has been pledged as collateral for those credit facilities.

The Company expects that working capital requirements and capital additions will be funded through a combination of internally generated funds, existing facilities and the proceeds from the exercise of stock options.

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