Accrual Ratio: Is a Company’s Profit Actually Backed by Cash?

Two companies post the same ₹120 crore profit for the year. One collected most of that money in cash. The other is still waiting for customers to pay, and has quietly piled up inventory too. The profit and loss statement treats them as twins. The accrual ratio is a simple way to tell them apart, and once you start using it you’ll find yourself checking it before you get excited about any earnings beat.

This guide walks through what the ratio measures, the two common ways to calculate it, a fully worked example with made-up numbers, and how we’d actually use it while reading an Indian company’s annual report.

What the accrual ratio actually measures

Start with the word accrual. Under accrual accounting, a company books revenue when it delivers a good or service, even if it hasn’t been paid yet, and books an expense when it receives something, even if it hasn’t paid for it yet. Wikipedia’s entry on accruals puts it plainly: accrued revenue shows up as income on the income statement and as accounts receivable on the balance sheet, and when the cash finally arrives the income statement doesn’t change; only receivables fall and cash rises.

That is perfectly normal. Almost every business sells on some credit. The problem starts when a large and growing slice of reported profit sits in these non-cash entries rather than in the bank.

The accrual ratio puts a number on that slice. As the Finance Toolkit documentation on the accruals ratio describes it, the ratio measures the part of earnings that is not backed by cash, relative to the average of total assets at the start and end of the year. The same page notes it also goes by the names Sloan ratio and earnings quality ratio.

Profit is an opinion built on accounting choices. Cash in the bank is much harder to argue with, and the accrual ratio measures the gap between the two.

Why anyone started caring about it

The ratio is tied to the work of Richard Sloan, whose 1996 paper in The Accounting Review (volume 71, issue 3, pages 289-315) asked whether stock prices fully reflect the information in accruals and cash flows about future earnings. According to the Finance Toolkit summary, Sloan showed that earnings driven by accruals are less persistent than cash earnings, and that companies with high accruals went on to earn lower future returns. That pattern is now called the accrual anomaly.

Put simply: profit that comes with cash tends to repeat. Profit that comes mostly from paper entries is more likely to fade.

Two ways to calculate the accrual ratio

There are two standard versions. Both appear on the Finance Toolkit page, and both divide by average total assets so that big and small companies can be compared.

1. The balance sheet version (Sloan’s original)

Balance sheet accruals ratio = [(Change in current assets − change in cash) − (change in current liabilities − change in short-term debt − change in taxes payable) − depreciation] ÷ average total assets

The logic: if non-cash current assets such as receivables and inventory grow faster than operating liabilities such as payables, profit is being built on working capital rather than collections. Cash is stripped out because cash isn’t an accrual. Short-term debt and taxes payable are stripped out because they’re financing and tax items, not operating ones. Depreciation is subtracted because it’s a non-cash expense that already reduced profit.

2. The cash flow statement version

Cash flow accruals ratio = (Net income − cash flow from operations − cash flow from investing) ÷ average total assets

In words, this is profit minus free cash flow, scaled by assets. The Finance Toolkit page explains why many analysts prefer it. Hribar and Collins (2002, Journal of Accounting Research) showed that the balance sheet method misstates accruals when a company acquires, divests or discontinues a business, because balance sheet changes then include items that never passed through operations. Their own measure was earnings before extraordinary items minus cash flow from operations. Subtracting investing cash flow as well treats spending on long-term operating assets as an accrual too, in line with the broader definition used by Richardson, Sloan, Soliman and Tuna (2005, Journal of Accounting and Economics).

For a retail investor working from an annual report, the cash flow version is usually easier. Net profit, operating cash flow and investing cash flow are three lines you can read straight off the statements. No need to rebuild working capital changes by hand.

A worked example with two hypothetical companies

The numbers below are invented purely to show the arithmetic. They don’t belong to any listed company.

Both Company A and Company B report net profit of ₹120 crore for the year. Both started the year with total assets of ₹900 crore and ended it at ₹1,100 crore, so average total assets are (900 + 1,100) ÷ 2 = ₹1,000 crore for each.

Company A

Cash flow accruals = 120 − 60 − (−50) = 120 − 60 + 50 = ₹110 crore.

Accrual ratio = 110 ÷ 1,000 = 0.11, or 11% of average total assets.

Watch the sign on investing cash flow. It’s negative because money went out to buy assets, so subtracting a negative number adds it back. That’s the formula doing its job: profit of 120 minus free cash flow of 10 leaves 110 of profit not backed by cash.

Company B

Cash flow accruals = 120 − 140 − (−30) = 120 − 140 + 30 = ₹10 crore.

Accrual ratio = 10 ÷ 1,000 = 0.01, or 1% of average total assets.

Same headline profit. Very different stories. Company B’s operations actually threw off more cash than its reported profit, and after capital spending only a sliver of profit is unbacked. Company A converted half its profit into operating cash and then spent most of that on investment.

The narrower Hribar-Collins style check

If we only take profit minus operating cash flow, Company A comes to (120 − 60) ÷ 1,000 = 6%, and Company B to (120 − 140) ÷ 1,000 = −2%. A negative number means operating cash flow beat profit. The ranking doesn’t change, which is typical, but the gap narrows because capital spending is no longer counted.

The balance sheet version, worked through

Now suppose, again hypothetically, that for some third company current assets rose by ₹150 crore during the year, of which ₹20 crore was cash. Current liabilities rose by ₹70 crore, including ₹10 crore more short-term debt and ₹5 crore more taxes payable. Depreciation was ₹40 crore and average total assets were ₹1,000 crore.

• Non-cash current asset change: 150 − 20 = 130
• Operating current liability change: 70 − 10 − 5 = 55
• Accruals: 130 − 55 − 40 = ₹35 crore
• Accrual ratio: 35 ÷ 1,000 = 3.5%

Receivables and inventory grew by more than payables, which pushed accruals up. Depreciation pulled them back down.

How to read the number

The Finance Toolkit page states that values near zero or negative are a sign of high earnings quality. Positive and rising values point the other way. Beyond that, there’s no universal cut-off that applies across every sector, and we’d be careful with anyone who hands you one.

A few practical rules we follow:

• Compare a company with itself over several years. One high year can be explained by a big order delivered in March. Three rising years in a row deserves a proper look at receivables and inventory notes.
• Compare within a sector. A capital goods maker with long project cycles will naturally carry more receivables than an FMCG company that sells to distributors on short credit. Comparing their ratios directly tells you little.
• Know which version you’re using. The cash flow version counts capital spending; the balance sheet version doesn’t. A company in a heavy capex phase will look worse on the first one even if its collections are fine.
• Check the sign, then check the trend. A ratio drifting from negative towards positive while profits are growing fast is exactly the pattern Sloan’s research warns about.

A single year’s accrual ratio is a question. Three years of it, moving the same direction, starts to become an answer.

What usually pushes accruals up

High accruals don’t automatically mean anything shady. Fast-growing businesses build receivables and stock simply because they’re growing. Still, the Wikipedia article on earnings quality lists accounting choices that can lower the quality of reported earnings, and several of them show up directly in accruals:

• Recording revenue too soon, or revenue of questionable quality
• Shifting current expenses to a later period
• Failing to record, or improperly reducing, liabilities
• Boosting income with one-time gains

The first three tend to inflate receivables or shrink payables and provisions, which is exactly what the balance sheet formula picks up. The same article notes that management judgment over things like depreciation methods and useful lives leaves room for both honest errors and manipulation, which is one more reason to lean on cash-based checks.

Using the accrual ratio on an Indian annual report

Here’s the routine we’d follow for any listed company:

1. Open the annual report and go to the consolidated cash flow statement. Note profit, net cash from operating activities and net cash used in investing activities for the latest year and the prior two or three.
2. Take total assets from the balance sheet for each year end and average consecutive pairs.
3. Run the cash flow formula for each year. Put the results in a small table.
4. If the ratio is high or climbing, read the notes on trade receivables, inventory and contract assets. Check whether receivable days are stretching.
5. Look at what’s inside investing cash flow. Large purchases of mutual fund units or fixed deposits are typically reported under investing activities too, so a company parking surplus cash can look as if it has high accruals when it’s really just moving money around. Adjust for that before drawing conclusions.

That last point matters more in India than people expect. Plenty of cash-rich companies move treasury money in and out of liquid investments every year, and those flows can swamp genuine capital spending in the investing section. If that’s happening, the narrower profit-minus-operating-cash-flow check is the cleaner one to rely on.

The accrual ratio pairs naturally with a few other checks. Our guide on operating cash flow vs net profit covers the simpler conversion check, and the step-by-step guide to analysing quarterly results shows where cash flow fits into a full results review. If accruals look stretched, the Beneish M-Score is a sensible next screen.

Limits worth keeping in mind

The ratio is a screen, not a verdict. Banks and NBFCs don’t fit it well at all, because lending and deposits run through operating cash flow and swing it wildly. Very young companies with tiny asset bases produce noisy readings. Seasonal businesses can look odd depending on where the financial year ends.

It also says nothing about valuation. A company with clean, cash-backed earnings can still be expensive. What the accrual ratio does well is stop you from paying up for profit that hasn’t turned into money yet. That alone makes it worth the five minutes it takes.

Disclaimer: This article is for educational purposes only and is not investment advice. The company figures used in the examples are hypothetical. Please do your own research or consult a SEBI-registered investment adviser before making investment decisions.