Accruals sometimes can give a tip off to the earnings quality of a business. As we all learned in our first lesson in Accounting, cash coming in and leaving the business is not equivalent to accounting income. Almost every line item on the balance sheet requires some kind of decision regarding when to recognize a transaction and a determination of how to value it. Income and balance sheet values can therefore fluctuate significantly based on how conservative or how aggressive the business is. Ratios that help measure the significance of accruals are a valuable measure to help determine earnings quality.

By looking at the balance sheet and cash flow statement, ratios can be calculated to determine the impact of accruals.

Balance Sheet Accruals Ratio = (Net Operating Assets for the current period less Net Operating Assets for the prior period) / [(Net Operating Assets for the current period plus Net Operating Assets for the prior period)/2]

Net operating assets are defined as: (total assets less cash)  less (total liabilities less debt)

Cash Flow Statement Accruals Ratio = [net income less (cash flow from operations plus cash flow from investments)] / [(Net Operating Assets for the current period plus Net Operating Assets for the prior period)/2]

Sloan Ratio* = [net income less (cash flow from operations plus cash flow from investments)] / total assets

An analyst can take the above calculations and compare them to historical ratios for the business as well as against the competition.

John Mahedy from Bernstein Investment Research and Management has a good write-up on the power of Balance Sheet Accruals.

*named for former University of Michigan researcher Richard Sloan