The Accrual Ratio and Cash Conversion
Two companies can report identical net income while one earned it almost entirely in cash and the other mostly on paper — the accrual ratio is the single number that tells you which is which.
Prerequisites: The Cash Flow Statement, The Sloan Accruals Anomaly
Net income is built from two ingredients: cash the business actually collected, and accruals — revenue booked but not yet collected, expenses matched but not yet paid, reserves estimated rather than settled. The accrual ratio measures how much of reported earnings is the second ingredient, and a body of research going back to Richard Sloan's 1996 paper shows that the accrual-heavy half of the market tends to underperform the cash-heavy half over the following year.
Accrual ratio = (Net Income − Cash Flow from Operations) / Average Total Assets. A high accrual ratio means earnings are running well ahead of the cash backing them up — often a sign of aggressive revenue recognition, understated reserves, or working capital quietly building up, and historically a predictor of weaker forward returns.
Reading the ratio
A ratio near zero means net income and CFO are moving together — earnings are, roughly, cash. A large positive ratio means income is being generated on paper faster than in the bank: receivables growing faster than sales, inventory piling up, or provisions being released rather than genuinely earned. The closely related cash conversion ratio (CFO / Net Income) tells the same story inverted — a healthy business typically converts something close to, or more than, all of its reported income into operating cash over a full cycle; a ratio persistently well below 1 is the same warning flag from the other direction.
Worked example
Company A reports net income of $100m and CFO of $95m; on average assets of $1bn, its accrual ratio is (100 − 95)/1,000 = 0.5%, close to zero — earnings are largely cash-backed. Company B reports the same $100m net income but only $40m of CFO, driven by receivables and inventory that grew much faster than revenue; on the same $1bn asset base, its accrual ratio is (100 − 40)/1,000 = 6%, a level that historically sits in the higher-risk tail. Company B's cash conversion ratio of 40/100 = 0.40 tells the same story: only 40 cents of every reported dollar of income showed up as operating cash.
What this means in practice
Screening for the accrual ratio, alongside the individual drivers (days sales outstanding, days inventory outstanding, changes in reserves), flags companies where reported growth in earnings is not being matched by growth in cash — useful both as an earnings-quality check on an individual name and as a systematic factor tilt away from the accrual-heavy part of the market.
A single high-accrual quarter isn't automatically a red flag — working capital swings around genuine growth (building inventory ahead of a strong season) can look identical to earnings management on a one-quarter snapshot. Look for the pattern persisting across multiple periods before concluding it's a quality problem rather than a growth story.
Related concepts
Practice in interviews
Further reading
- Sloan, 'Do Stock Prices Fully Reflect Information in Accruals and Cash Flows?', The Accounting Review (1996)