Cash flow and earnings quality
Earnings quality and accruals
Compare earnings with cash flow and measure how much of profit is accruals.
Learning objectives
- Calculate accruals as net income minus cash from operations
- Calculate a cash-flow-based accruals ratio on average total assets
- Interpret a rising accruals ratio without overstating it
Accrual accounting records revenue when earned and costs when incurred, not when cash moves. That makes profit a better measure of performance — but it also means profit depends on estimates: how much of receivables will be collected, whether inventory will sell at full price, how long assets will last.
Earnings quality asks how well reported profit is backed by cash. High-quality earnings convert to cash over time; earnings that rest increasingly on accruals (growing receivables, inventory, capitalised costs) are more likely to disappoint. Research has long found that companies with high accruals tend to see lower future earnings.
Accruals = NI − CFO Accruals ratio = (NI − CFO) ÷ avg Total assets Cash backing = CFO ÷ NI
- NI − CFO
- the part of profit not (yet) received in cash; negative is normal for a company with large D&A
- avg Total assets
- scales accruals so companies and years are comparable
Included with a Formula Quest membership
The rest of this lesson is for members. Members get the full lesson, including its 3 graded exercises, and every other Finance Quest lesson.