If you are considering an investment, the cash-flow-based accrual ratio can help you choose a company in which to invest. Cash flow is the money “flowing” in and out of a company. This ratio uses components of the cash flow statement and other financial statements to help you identify a smart investment. SmartMoney’s Paul Sturm states, “Companies with strongly negative accruals ratios (cash flow that exceeds earnings) are consistent winners.” Once you can calculate this ratio, you can start choosing “winning” investments.
Cash Flow Accrual Ratio
There are a few accrual ratios based on a company’s financial statements. One in particular is based on a company’s cash flow statement. This accrual ratio examines the company’s net income less its cash flows from investing and operating activities, and it compares this number with the average “net operating assets” over a particular time period.
You can gather the information for the cash-flow-based accrual ratio by viewing a company’s financial statements. Net income is found on the income statement. Cash flows from investing and operating activities are found on the cash flow statement. Locating net operating assets is a little bit more complicated. To obtain this information, the company’s balance sheet must be reconfigured. Financing activities must be separated from operating activities. Net operating assets are just the company’s operating assets minus its business liabilities.
Assume Company A wants to calculate is cash-flow-based accrual ratio. Taking a look at its financial statements, Company A’s net income is $125,000. Company A’s cash flows from investing activities are $25,000, and its cash flows from operating activities are $30,000. The senior accountant at Company A has reconfigured the balance sheet to separate financing activities from operating activities, determining that net operating assets are $40,000. To calculate the ratio, Company A must take net income and subtract cash flows from operating and investing activities. This number is divided by the net operating assets. Company A’s cash-flow-based accrual ratio is 1.75, or ($125,000 - $25,000 - $30,000) /$40,000.
If you are considering an investment, the cash-flow-based accrual ratio tells you about the quality of a company’s earnings. Investors should try to invest in companies that have a negative cash-flow-based accrual ratio. This means the cash flow component of the ratio is higher than net income. This means the company’s earnings were based more on cash items than on non-cash items, such as the accrual items that are part of net income. This indicates a smarter investment because cash indicates liquidity rather than having money tied up in accruals.