How does Sloan's accruals decomposition identify low-quality earnings?

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AcadiFi · Accepted Answer

Sloan decomposed earnings into a cash component and an accrual component, showing that firms with high accruals experience lower future earnings and stock returns. The classic balance-sheet accrual ratio is:

Accrual Ratio = (NI - CFO - CFI) / Average NOA

where NOA is net operating assets. A simpler cash-flow-statement version:

Accruals = NI - CFO

Scaled by average total assets. Walk through Pinewood Logistics: NI of $310M, CFO of $180M, average total assets $2.4B. Accrual ratio = (310-180)/2400 = 5.4%. Sloan found firms in the top decile of accrual ratios (typically above 10%) underperform low-accrual deciles by 8-10% annually for three years. Why? High accruals mean earnings are built on receivables growth, inventory builds, capitalized costs, or reduced allowances. These reverse. For Pinewood, if receivables grew $140M and inventory grew $90M while sales rose just 4%, the accrual is a warning. Decompose further into working capital accruals (ΔAR + ΔInv - ΔAP) and long-term accruals (depreciation deferrals, capitalized R&D). Compare to industry peers and the company's own 5-year history. A sudden jump from 3% to 12% accrual ratio paired with flat revenue growth predicts earnings disappointment within 4-6 quarters.

How does Sloan's accruals decomposition identify low-quality earnings?

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