The idea. Richard Sloan ("Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?", The Accounting Review, 1996) split earnings into a cash component and an accrual component and asked which one persists. His answer: cash earnings persist and accrual earnings fade. In his sample the persistence coefficient of the cash component was roughly 0.85, against roughly 0.77 for accruals (approximate, from the paper's regressions, so check there). Investors priced both alike. So the companies with the highest accruals, whose profits were made of bookkeeping more than cash, systematically disappointed. Rank all firms into deciles by accruals ratio. A portfolio long the lowest decile and short the highest earned about 10.4% per year in size-adjusted abnormal return in the first year after ranking, over 1962 to 1991 (his figure and his sample, so read the paper). This "accrual anomaly" is the most replicated result in forensic-flavored finance. Its raw returns have decayed since the 2000s as arbitrage capital moved in. As a quality and risk discriminator, though, it never stopped working: firms with extremely high accruals remain far likelier to restate, miss and blow up. For you, the accruals ratio is the fastest quality-of-earnings number there is. It takes one subtraction and one division.
Advertisement
How is the accruals ratio calculated?
Method 1, the cash-flow method. This is the one to prefer.
Accruals_CF = Net income (continuing operations) − CFO
Accruals ratio = Accruals_CF / Average total assets, Average TA = (TA_t + TA_{t−1}) / 2(Broader research variants also subtract CFI to capture investing accruals (Richardson et al. 2005). The CFA curriculum's "aggregate accruals" scales the change in net operating assets instead. Know they exist. The default here is NI − CFO over average TA.)
Method 2, the balance-sheet method. This is Sloan's original construction.
Accruals_BS = (ΔCA − ΔCash) − (ΔCL − ΔSTD − ΔTP) − Depwhere ΔCA = change in current assets, ΔCash = change in cash & equivalents, ΔCL = change in current liabilities, ΔSTD = change in debt within current liabilities, ΔTP = change in income taxes payable, Dep = depreciation & amortization. Scale by average TA. The intuition: accruals are the growth in non-cash working capital minus the non-cash depreciation charge. STD and TP come out because they're financing items that don't belong to operations.
Why two methods, and which to trust. Hribar & Collins (Journal of Accounting Research, 2002) showed that the balance-sheet method breaks whenever balance-sheet changes come from something other than operations. Acquisitions, divestitures and currency translation all move working-capital balances without any accrual being booked. Remember acquisitions as a cash-flow pump: acquired receivables come in through CFI. The cash-flow method, built from the statements' own articulation, is immune. Use the CF method whenever a cash-flow statement exists. Use the BS method to cross-check, and investigate any large gap between them, because the gap itself is information.
Worked example: the accruals ratio both ways
Worked computation. Here's Kavery, run both ways.
CF method: Accruals = 130 − 25 = 105. Average TA = (1,000 + 1,400)/2 = 1,200. Ratio = 105 / 1,200 = +8.75%.
BS method: ΔCA = 660 − 450 = 210; ΔCash = 45 − 60 = −15 → (ΔCA − ΔCash) = 225. ΔCL = 376 − 250 = 126; ΔSTD = 55 − 30 = 25; ΔTP = 24 − 20 = 4 → (ΔCL − ΔSTD − ΔTP) = 97. Dep = 44. Accruals_BS = 225 − 97 − 44 = 84. Ratio = 84 / 1,200 = +7.0%.
Reconcile the ₹21 crore gap (CF 105 vs BS 84). The land-sale gain of 25 is an accrual the working-capital method can't see, because it lives in non-current assets. The taxes-payable change of 4 is deliberately excluded by Sloan's BS formula but embedded in CFO. So 25 − 4 = 21. This small reconciliation is the Hribar and Collins lesson in miniature: the BS method goes blind right where the interesting accruals live.
How do you interpret the accruals ratio?
Interpretation. In Sloan's US sample the median firm ran mildly negative accruals, since depreciation usually outweighs working-capital growth. The danger decile sat roughly above +10% of assets ¹. Kavery at +8.75% is knocking on the top decile. That fits its M-Score flag. It fits its DSRI and AQI in particular: same disease, second thermometer. Signs matter. High positive accruals mean profits without cash, a quality risk. Deeply negative accruals can be a fine capital-intensive firm depreciating heavily. They can also be a shrinking firm liquidating working capital (Worked Example 3 shows one), or a big-bath year. So read the direction with its context. One note for India. Apply the ratio to consolidated Ind AS numbers, and standardize CFO first (see the classification traps), because interest-paid classification alone shifts the ratio by interest/assets. Expect structurally higher working-capital accruals in an economy growing at high nominal rates. Benchmark against Indian peers, not 1980s Detroit.
¹ Approximate: the decile cutoffs are sample-specific. So rank your own universe and read the extremes.