I cannot understand why Accruals Ratio’s = Earnings quality. The way I read the formula seems to suggest that the ratio gauges the % increase in Net Operating Assets (Change in NOA/avgNOA). How does that relate to earning quality? What is wrong with quickly growing Operating Assets?
I think its because operating assets and liabilities do not include cash or debt. Its saying your growing your assets without increasing your cash, hence the term accruals. If a firm has a lot of accruals its not as certain as having the cash.
You have an change in assets or liabilities due to the fact that you are “accruing” revenues or expenses. This is not a true measure of “earning” since these a. have the potential to reverse in the future (e.g. you accrued prepaid revenues from a deal, this makes the current period earnings look good, especially at the end of the year,e.g… but later the company reverses that deal out. If you used Net Income as a measure of earnings - you would be misled to believing the company is doing better than it really is. Accruals = removes the effect of the accrual. If you looked at the cash flow measure: NI - (CFO + CFI) --> the changes in assets / liabilities are being removed out from the Net Income… For a company - both the cash flow measure and the balance sheet measure should be close to each other. (may not match up in some cases, but more often than not they should).
From what I remember it is NI - Free cash flow / total assets… the NI - fcf tells you what amount of net income came from accruals which are up to accounting decisions. That divided by your total assets shows you what percent of your total assets are quality assets that are not subject to acct policy…
Ok, that makes sense, but saying that growing your accruals is negative seems to be incorrect, whereas saying something like “if youre accruals are growing faster than sales, this may very well be negative” would seem more appropriate…