Not All Earnings are Created Equal
Earnings is the main word that holds the greatest importance on stock market. Ironically, earnings is not real money. $1 in earnings does not equal $1 in cash a company has to spend. Earnings contain a lot of non cash earnings which is called accruals.
The non cash part of earnings includes things such as changes in accounts receivable, depreciation and amortization where no cash has been exchanged, but companies will book such transactions as earnings under the accrual accounting method.
It was first documented by Richard Sloan of the University of Michigan in 1996. Click here for the full research paper. He has written a number of academic papers comparing the future 12-month stock performance of companies that report earnings with a high degree of accruals versus companies that report earnings with a lower degree of accruals (i.e., earnings closer to, or even below, cash flow). Specifically, he measures the degree of a company’s accruals by an “accrual ratio,” which divides total accruals by the company’s net operating assets (NOA).
Thus, he gave birth to what we now know as the Sloan Ratio.
The Formula: Sloan Ratio
Sloan Ratio = (Net Income – CFO – CFI) / Total Assets
where, CFO = Cash From Operations, CFI = Cash From Investments
If the Sloan Ratio is between -10% and 10%, the company is in the safe zone and there is no funny business with accruals.
If the Sloan Ratio is less than between -25% and -10% on the negative side, and between 10% and 25% on the positive side, this is a warning stage of accrual build up.
If the Sloan Ratio is less than -25% or greater than 25%, and this ratio is consistent over several quarters or even years, be careful. Earnings are highly likely to be made up of accruals.
The Formula: Balance Sheet and Cash Aggregate Accrual Ratio
First calculate Net Operating Assets:
Next, subtract last period’s NOA from the current NOA figure to arrive at Balance Sheet Aggregate Accruals.
The Balance Sheet Aggregate Accruals Ratio is determined by dividing that number by the average accruals.
The procedure is similar when calculating Cash Flow Aggregate Accruals, as shown below.
There are basically two main application of the Sloan Accrual Ratio:
- To Check for Earnings Quality
- Analyzing accruals to pick winners
A Deeper Look on Earnings Quality with Sloan Accrual Ratio
Sloan ratio, balance sheet and cash flow accrual ratio can be use it to watch out for the following:
- A jump in earnings accompanied by a jump in the accruals ratio should raise a red flag.
- High balance sheet 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.
- Companies with low balance sheet accruals tend to have below average returns on equity.
- 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.
Let us compare the ratios for two companies in the same industry.
Sloan Accrual Ratio for OKA (Click to enlarge)
Sloan Accrual Ratio for Humeind (Click to enlarge)
Next up on how to pick winners by analyzing accruals.