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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.

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