Understanding Accruals Ratio
Accruals Ratio measures the company's revenue and incurred expenses that impact its income statement and balance sheet, representing its non-cash assets and liabilities. By measuring this financial metric, analysts can identify how sustainable a company's earnings are. It is calculated by subtracting free cash flow from net income divided by total assets. The accruals ratio includes factors such as account receivable, accounts payable, future tax liabilities, future expenses, accrued interest earned or payable.
The formula to derive Accruals Ratio
Free Cash Flow - It measures the company's financial performance and cash the company generates after accounting for cash outflows to support operations and maintain capital assets. It is calculated by subtracting operating cash and capital expenditures and found in the Cash flow statement.
Net Income - Net Profit or Net Income is measured by sales minus the Cost of goods sold, general and administrative expenses, operating expenses, other expenses, depreciation, interest, taxes, etc. Net Income is found in the Income statement of the company.
Total Assets - Total assets are the total number of assets owned by a person or company. Total assets are reported on a company's balance sheet.
Example of Accruals Ratio: For the financial year, United Spirits reported Net Income as Rs. 383.60 Cr., Free Cash Flow as Rs. 1644, and Total Assets as Rs. 8537 Cr.
The value as per the formula (Net Income - Free Cash Flow / Total Assets) is calculated as (383.60 - 1644 / 8537) = -0.15.
Key Highlights
The Accruals Ratio is calculated by subtracting free cash flow from net income divided by total assets.
If the Free Cash Flow is higher than Net Income or Cash Earnings are higher than Accrued Earnings, the accruals ratio will be negative, which is considered good as it indicates high cash generation by a company.
An accrued concept refers to recording earnings or expenses at the time they are incurred, not as they are received or paid.
While looking at the Accruals Ratio, the following points should also take into consideration:
A low accruals ratio is considered good, but investors should check other factors behind it. Because if the accruals ratio is very low or negative, that means the free cash flow is high compared to its net income, which may suggest that the company is not utilizing its free cash.
If the Free Cash Flow is higher than Net Income or Cash Earnings are higher than Accrued Earnings, the accruals ratio will be negative, which is considered good as it indicates high cash generation by a company.
Despite being necessary for obtaining an accurate picture of a company's performance, accruals are subject to management discretion and may be manipulated by management.
Many investors used this metric to analyze whether the company was concealing its solvency issues through its accounting procedures.
A high accrual ratio indicates the company relies more on accruals to keep the financial picture positive. If the company's accruals ratio is high but its outstanding days are near 30 days, there is nothing to worry about. And opposite to this, if the accruals ratio is high and its outstanding days are also high, then investors think before making any decisions.
How to use Accruals Ratio effectively
Investors should look for a low accruals ratio. But also must check other factors when the accruals ratio is too low.
While analyzing the accruals ratio, always compare companies that operate in the same industry.
By looking at a single ratio, we cannot analyze the performance of the company so, with Accruals Ratio we should look at other financial metrics such as
Account Receivable Days,
Opex Ratio,
Free Cash Flow to Revenue Ratio, etc.,
