Checking Financial Accruals of a Company in 5 Minutes

December 27, 2011 | Comments (7)

Companies with low balance sheet accruals out performed companies with high balance sheet accruals by 8-10%. Majority of my focus has been on cash flow where there is less room for accounting manipulation because in the real world, we pay cash for something and receive cash for products or services rendered. Accrual accounting attempts to fix such issues by matching costs with related revenues but he problem is that this method introduces subjective judgments and assumptions. Here are some other quick observations regarding accrual accounting you need to understand.


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Jae Jun

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A week or so ago, I had a guest post about accruals and determining quality of earnings and since then, I’ve implemented an accrual analysis section in the stock valuation models and financial accruals.

Rather than going over the whole accrual topic again, read the article on determining earnings quality through accruals.

Financial Accruals and the balance sheet

Signal of Future Stock Performance?

Based on a 6 page report (pdf) produced by Bernstein Investment Management and Research, companies with low balance sheet accruals out performed companies with high balance sheet financial accruals by 8-10%.

Other than the equations for finding the accrual ratios from the previous post, I don’t have any information on how Bernstein modified their conditions to get the results, but the theory is the same and is important to understand.

Cash Flow vs Financial Accruals Accounting

Majority of my focus has been on cash flow where there is less room for accounting manipulation because in the real world, we pay cash for something and receive cash for products or services rendered.

This is an ideal scenario and is basically means that earnings should equal the change in cash.

However, this would cause accounting issues as a business could spend a lot of money building inventory one year and not selling it until the next.

Accrual accounting attempts to fix such issues by matching costs with related revenues but he problem is that this method introduces subjective judgments and assumptions.

Here are some other quick observations regarding accrual accounting you need to understand.

Accrual Accounting Observations

(Read the PDF for detailed explanations.)

  • Earnings growth due to accrual growth is not sustainable. This is like cookie jar accounting where a company “borrows” earnings from the future to make earnings look good today.
  • Balance sheet accrual can indicate whether capital is being used properly. A company with high accruals can come from acquiring or merging with companies which expands the asset base. Low balance sheet accrual companies tend to shrink their balance sheet through spin offs, share repurchases or large write offs. In these situations, it is usually removing bad performing assets or returning money to shareholders which is always a good use of capital.
  • High accruals indicate that the company has expanded its asset base rapidly.
  • Companies with high balance sheet accruals tend to have higher sales growth than low balance sheet accrual companies.
  • High balance sheet accruals also have a higher ROE.
  • Remember that maintaining a high sales growth or high ROE is difficult unless you have an entrenched moat. Such companies revert to the mean and disappoints analysts.
  • Companies with low balance sheet accruals tend to have below average returns on equity. Analysts expect the company to lag.

All of this sounds a like regular value investing and contrarian investing principles.

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Examples to Analyze

Let’s analyze an example to nail the concepts into our heads. You and I have the benefit of hindsight bias with these examples.

financial accruals

Balance Sheet Financial Accruals

I’ve chosen DLB as my first example because it is a current holding of mine and it’s always a good idea to challenge current holdings with new ideas.

Both the balance sheet and cash flow accrual for DLB has been growing quickly. The accrual ratios suggest that DLB relies on accruals to post positive earnings. But the assumption can’t just end there.

Cash has been increasing with decreasing debt, total liabilities well under control with consistently increasing net income.

If net income drops with accruals increasing, watch out.

The Sloan ratio is best when kept below 8%. You see in 2007 – 2009, it was much too high. It may have been that all those accruals finally got to the stock price in 2010 as it hit $70. Then with news that DLB won’t be included in Windows 8, the stock reverted to the mean level where all future revenue for Windows 8 is removed.

Do Accruals Indicate Stock Performance?

I must have gone through about 20 companies to try and find a obvious example, but it is much harder to find that I thought. Many companies with horrible accruals ended up shooting up with a stock price still strong after 5 years.

I’m not surprised though because the accrual ratio is still just one way of analyzing a company’s health.

A better way to go about doing it would be to compare direct competitors to see how the ratios stand within the industry.

Your Homework

Here is your  mission. Go through the numbers quickly for Western Digital (WDC) and tell me what you think about its accruals.

You shouldn’t take more than 5 minutes.

There is no right or wrong answer as this analysis still involves some subjective thought processing.

Final Thoughts

Red warnings signs won’t show up for every stock that you look at. If you do this exercise with AAPL, you will notice that it breaks all rules. As a cash flow investor, I’ve focused most of my energy on the cash flow until now, but understanding how that cash flow is related to earnings is a great check to include in your analysis.

The financial accruals ratio won’t help you find killer investments, but it will help with building a healthy portfolio. I’ve yet to see how I can fully maximize the lessons from here myself, but I will definitely be including a check in the accruals in my investment process and stock valuation models to speed things up.

About Jae Jun


Jae Jun is the founder of Old School Value. He is on a mission to provide practical and actionable value investing tools, tutorials and educational material to help empower the individual investor. Keep in touch with Jae via any of the methods linked below.

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  • James DeMasi

    Hi Jae,

    Let me see if I can shed some light on this subject matter. I wish I had done a little more research to refresh my memory (I hadn’t done much analysis while finishing my MBA) before writing my post but at least it got the conversation started.

    Well, what we are really looking for here is earnings persistence. Persistent earnings = sustainable = high quality. Managers have discretion over accruals and that makes accrual earnings less reliable and more subject to the possibility of manipulation. As such, it is advised that the accrual portion of a company’s earnings be given a lower multiple. I kind of glossed over it but remember in my post when I said Accrual earnings = Cash earnings + aggregate accruals and that accruals are mean reverting? Well, the level of accrual earnings relative to the earnings figure will help to determine just how quickly the earnings are likely to revert. A quick reversion is more likely as accrual earnings make up a larger portion of the total earnings figure. The example you gave of Western Digital is a great one to illustrate the point we’re trying to make here.

    In almost every year, aggregate accruals are very high compared to net income. This would seem to indicate that a large portion of WDC’s earnings and earnings growth comes from accruals rather than cash. Therefore, their earnings should be less reliable and less persistent, and we see that they are. Each year the company’s earnings are practically doubling or being cut nearly in half. Their earnings are unreliable and not persistent at all. Trying to predict the company’s sustainable earnings would be a difficult task. Looking at their reported earnings makes that statement obvious, but we could have also determined that by seeing that their earnings are of poor quality. Therefore, an investor in Western Digital runs the risk of an earnings shock and should be cautious about buying the company at higher valuations. In other words, they should not be fooled by a good year into thinking that the big earnings number actually meant something and reflects the true sustainable earnings power of the company.

    Dolby is a little more interesting because the logic of it all isn’t as clear cut as Western Digital. You can look at WDC’s accrual reversals and then scroll down and see the earning reversals. The volatility one would predict in the company’s earnings is there. Dolby has high accruals levels as well but the earnings still look more persistent than WDC did. Even the year where the accruals reverted the company showed earnings growth, albeit slower growth than the previous years. Maybe some more investigation should be done into Dolby to really figure out how persistent the company’s earnings are. Compare the operating income to their operating cash flow and see if there are any large disparities there.

  • http://www.oldschoolvalue.com Jae Jun

    Here’s another link I received from a reader on this topic discussing that this is old and has no point.
    http://www.foster.washington.edu/centers/facultyresearch/Pages/accruals-anomaly-demise.aspx

    But I would like to know exactly how many hedge funds or investors even perform this task. Not many I think.

  • http://www.oldschoolvalue.com Jae Jun

    Another reader submitted link.
    This one shows the performance of how using accruals outperforms.

    http://www.cxoadvisory.com/1578/fundamental-valuation/gaming-the-earningsaccruals-gamers/

  • Emeka Igboanugo

    Jae & James – Very insightful posts on accruals! An additional tool to help in understanding the quality of earnings.
    Jae – Please let us know if/when you incorporate this with the spreadsheet.

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  • guest1618

    Jae,
    I appreciate your site, in general so first i wanted to thank you for that.
    I wanted to note two things with regards to DLB.

    you say..”Both the balance sheet and cash flow accrual for DLB has been growing quickly. The accrual ratios suggest that DLB relies on accruals to post positive earnings. But the assumption can’t just end there.”

    Each year CFO was more than NI. Therefore, wouldn’t it be more accurate to say it appears that DLB has used accruals to depress its earnings (NI)? As I understand the work done in this area, OCF that is significantly below NI could be a warning sign…while OCF that is significantly in excess of NI is potentially positive (i.e. cash flow is more sticky than accrual driven NI).

    Also, importantly, your balance sheet, while probably technically correct is misleading, in my opinion. DLB has made little or no acquisitions over this time and the cash they make just piles up almost dollar for dollar on the balance sheet. So a huge part of that balance sheet growth is cash piling up. However, one wouldn’t see that from your abridged balance sheet because a significant amount of that cash is not in “cash & eq” but in “short term investments” which you just lump into “total assets”.

    It appears that this mischaracterization (which is what i would call it, for analysis purposes) of the cash will have an impact on your NOA calculations and therefore your accrual calculation and so potentially should even deserve to be considered in this light.

    Sorry if I’ve made any errors. I hope that was helpful in some way.

    disclosure: long DLB

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