Lesson 2 of 9
Accruals and the cash check
Net income minus cash from operations, scaled by assets, separates profit you collected from profit you estimated.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Accruals are net income minus cash from operations, the part of profit estimated rather than collected; over average total assets they are the accrual ratio.
- A company that pays a large part of its workforce in shares shows a structurally negative accrual ratio, for a compensation reason, not an earnings-quality one.
- One year's ratio is noisy, so ten years of cash from operations summed against ten years of net income is the sturdier check.
Profit has two parts. One was collected in cash. The other was estimated, and the estimate is the company's own. Subtracting cash from operations out of net income, then dividing by average total assets, is how you separate the two, and it takes about five minutes once you know where to look.
Sloan's 1996 paper in The Accounting Review found the estimated part less persistent than the cash part, and share prices behaved as though investors did not tell them apart.
Net income to operating cash flow
- Net income$100
- Depreciation and amortisation+$30
- Stock-based compensation+$25
- Receivables grew−$15
- Operating cash flow= $140
The computation, in one line
Accrual ratio equals Net income − cash from operations divided by Average total assets.
Example($100 − $140) ÷ $1,200 = −3.3%
Net income sits at the foot of the income statement. Cash from operations is the subtotal at the foot of the first section of the cash flow statement.
Average total assets is last year's total plus this year's, divided by two. A year of income should not be divided by a balance sheet from one day.
Everything between net income and cash from operations on that statement is the list of accruals themselves, itemised by the company, and the subtraction just totals a list the filing already printed.
Why stock pay skews it
Share-based compensation is an expense on the income statement and a non-cash add-back on the cash flow statement. It lowers net income and does not lower operating cash flow. A company that pays a large share of its workforce in stock will show operating cash flow above net income for that reason alone.
Read that as a conservative accrual profile and you have read a compensation policy as an accounting virtue. The same is true of any large non-cash charge. Depreciation, amortisation and impairments all push operating cash flow above net income, for reasons unrelated to the durability of earnings.
Where a high ratio is expected
A company growing revenue quickly has large positive accruals for an ordinary reason: receivables and inventory grow with sales, and both consume cash before profit is collected. In one fast-growing year a high ratio is expected, and on its own it points to nothing wrong. What is worth asking is whether accruals are growing faster than revenue, not merely whether they exist.
Ten years, summed
A single year's ratio is noisy. Over ten years, timing swings in receivables and inventory mostly wash out, so the sum is steadier. Depreciation and stock pay never wash out: they keep cash above profit for good. So read the direction. Cash above profit is the normal shape. Profit above cash for a decade needs explaining, and growth is the first explanation to check.
Ten years of profit against ten years of cash
- Net income, ten years summed$1,000
- Operating cash flow, ten years summed · $80 below profit$920
A decade of profit above cash is worth an hour in the receivables and inventory notes. One year's swing is worth one note.
Check yourself
Accruals are computed as what?
- Cash from operations minus net income
- Net income minus cash from operations
- Net income divided by total assets
Show the answer
Answer: B.
The order sets the sign: net income minus cash from operations, then scaled by average total assets.A company pays much of its workforce in shares. What happens to its accrual ratio, and why?
- It rises, because compensation is a real cost
- It falls, because the expense lowers net income but is added back in reaching operating cash flow
- Nothing changes
Show the answer
Answer: B.
The expense reduces net income and never touches cash from operations, so operating cash flow sits above net income for a compensation reason, not an earnings-quality one.A fast-growing company shows a large positive accrual ratio in one year. What is the most likely explanation?
- The company is manipulating earnings
- Receivables and inventory are growing with sales, ahead of the cash they will collect
- The company is about to fail
Show the answer
Answer: B.
Growing operating assets consume cash before profit is collected. It becomes a real question only when accruals grow faster than revenue does.Sources
- Sloan, "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?", The Accounting Review, 1996: the accrual component of earnings is less persistent than the cash component, and prices behaved as though investors did not distinguish them. He measured accruals from balance-sheet changes, not from the cash flow statement.
- ASC 718, Compensation, Stock Compensation, on the non-cash add-back for share-based pay.
What this leaves out
- This test compares one company's own figures across time, and this lesson prints no distribution ranking it against a market.
- The measure assumes an operating business, because for a bank or an insurer, cash from operations includes lending and underwriting flows, and the ratio is not comparable with anything.
- The waterfall, the two-year table and the ten-year figures all use round invented numbers, chosen so the arithmetic can be checked by hand.
- Nothing here is advice about any security.