# Earnings Quality - Accrual Ratios

Can someone explain the logic of these formulas in determining earnings quality? Schweser does not do a thorough job at explaining why these formulas make sense. These will not be hard to memorize, but I’d like to understand the concept. 1) (NOA end - NOA beg) / (Avg NOA) 2) (NI - CFO - CFI) / (Avg NOA)

I think the 2nd equation should be >> [NI - (CFO + CFI)] / (Avg NOA). I think CFI is often a negative number. You put more weight on cash than you put on accrual. The higher the accrual amount/percentage allocated to earnings, the lower the quality of earnings.

damil - expand out the - sign inside and you have the same thing. in the equation form presented in both cases- remember to use the CFO and CFI numbers with the actual signs. End NOA - Beg NOA -> keeps the effect of Balance sheet based accruals. NOA = [Total Assets - Cash] - [Total Liabs - Debt] Cash and Debt have much less discretion embedded in them usually. So removing them and taking difference of NOA from 1 period to the next - shows impact of accruals on the Balance sheet. Different companies have different sized balance sheets. So you factor in the different sizes of the balance sheets by dividing difference in NOA by the Avg NOA. NI - {CFO+CFI} NI -> Net Income in a period. CFO -> what were the Actual Cash flows from Operations. In this place you have a lot of accruals going on - remember the changes in the Current Assets and the Current Liabs. CFI -> also some accruals could be happening with respect to impact of deferring expenses by capitalizing expenses. --> this would show up in the CFI. CFF is not considered - since it is largely assumed to be accrual / discretion free. NI - [CFO+CFI] thus gives you the measure of accruals in the CAsh Flow Statements. Normalize this by dividing by average NOA, again, to take care of differences between different company sizes. The accruals ratios thus then become comparable.

cpk you are a saint!

This clears it up a little bit CPK, but I still don’t understand the relationship between NI and CFO & CFI. Take the following example: 1) Goldman Sachs invests a ton of its cash in equity securities one period 2) This results in a large negative CFI 3) The negative CFI is subtracted from NI in the numerator 4) This results in a large increase in the accrual ratio 5) The analyst then interprets this large accrual ratio to mean a low quality of earnings Now what did investing cash in equities have to do with accruals or earnings quality? What am I missing? Thanks to anyone that can set me straight.

investing cash in equities did not have anything to do with earnings quality. but if the investment had been in HFT securities, which increased in value - the NI would have increased. But is it really good earnings, or bad earnings would come by over time. The CFI by itself is used to take care of the fact that a company could be deferring expenses by capitalizing assets - which would come up in the CFI term… read the book and try to understand what they are trying to say… that is more meaningful. I am just giving a couple of scenarios here, where a good NI in one period, is not necessarily good… A manufacturing firm, having a ton of hft securities, which gained in value - would look good from a Net Income perspective, but this is not the core business of the firm. the chapter is a framework for detection of earnings quality issues…

cpk123 Wrote: ------------------------------------------------------- > investing cash in equities did not have anything > to do with earnings quality. > > but if the investment had been in HFT securities, > which increased in value - the NI would have > increased. But is it really good earnings, or bad > earnings would come by over time. > > The CFI by itself is used to take care of the fact > that a company could be deferring expenses by > capitalizing assets - which would come up in the > CFI term… > > read the book and try to understand what they are > trying to say… that is more meaningful. I am > just giving a couple of scenarios here, where a > good NI in one period, is not necessarily good… > A manufacturing firm, having a ton of hft > securities, which gained in value - would look > good from a Net Income perspective, but this is > not the core business of the firm. > > the chapter is a framework for detection of > earnings quality issues… +1

Another way to comprehend it could be: NI: Your Net Income consists of two components. 1) your Cash Earnings and 2) Earnings from accruals (i.e. credit sales, deferred expenses, depreciation expenses etc etc.) And we are interested in estimating the 2nd component. CFO: Your cash earnings (the first component) are captured in CFO. And this cash is spent in buying new Assets (that is cash outflow from CFI) Now, lets assume, your expenditure in New Assets exactly balances your depreciation expense for the year. Then, in absence of any Accrual Earnings, the following equation should hold true: NI + Dep = CFO - CFI outflow But because there ARE Accrual Earnings, the 2 sides will not equate and any difference between the 2 sides, would measure Accrual Earnings. This may give an insight why NI - CFO + CFI outflow, is a measure of Accruals. Now to answer your question: TheDooner64 Wrote: --------------------------- > 1) Goldman Sachs invests a ton of its cash in > equity securities one period > 2) This results in a large negative CFI > 3) The negative CFI is subtracted from NI in the > numerator > 4) This results in a large increase in the accrual > ratio > 5) The analyst then interprets this large accrual > ratio to mean a low quality of earnings > If large outflow in CFI is funded by similarly large CFO (your cash earnings), (as it should be), then there will NOT be a large increase in Accrual Ratio.

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This was the explanation I was looking for. Thanks very much rus1bus, you definitely cleared it up for me.