Analyzing Earnings Quality - the Accruals Ratio

• A company's accrual earnings has two components: cash earnings and aggregate accruals

Accrual Basis Earnings = Cash Earnings + Aggregate Accruals

Aggregate Accruals = Accrual Basis Earnings - Cash Earnings

• When aggregate accruals are the dominant component of a company's earnings, mean reversion tends to occur more quickly and so earnings with a high accrual component can be considered lower quality.

• Accruals Ratio - the accruals ratio is a simple measure for analyzing earnings quality. There are two approaches: the balance sheet approach and the cash flow statement approach.

• Two approaches to the Accruals Ratio:

• Balance sheet approach

• Cash flow statement approach

Balance Sheet Approach to the Accruals Ratio

Steps in evaluating aggregate accruals: the Balance Sheet Approach to the Accruals Ratio

Steps in evaluating aggregate accruals: the Cash Flow Statement Approach to the Accruals Ratio.

NOTE: The two approaches to calculating a company's accruals ratio will not result in the same value, but there is a high correlation between the methodologies.