Which stocks will spring earnings shocks?
By: Tim Bennett
03.08.2018
How can you test the quality and sustainability of a firm’s earnings? Tim Bennett takes a look at an important ratio in this week’s short video.

Which firms will deliver earnings shocks?

Every time “earnings season” comes around, there are stocks that surprise on the upside and others that deliver unpleasant surprises for shareholders. The key question is therefore, is there any way to spot the rogues in advance? Fans of the accruals ratio believe that there is.

What can go wrong

Company directors are under huge pressure to deliver better-than-expected results in earnings terms. This can lead to the temptation to try to move profits from one period to another – specifically, to try to book them early. This can happen because of something called the accruals principle.
Firms are allowed, under the accounting rules, to book revenue when it is earned and costs when they are incurred, which is not necessarily the same point at which cash is received or expenses paid. To understand why, think about a firm trying to woo new customers by offering credit terms of, say, 60 days. The invoice for the goods sold will go out (and the relevant sale booked) when they are delivered but the cash may not be received for 60 days or more. This creates a potential timing difference between what is recorded as earnings and the equivalent cash flow number – and this is just one of many such examples.

How profits can be flattered using accruals

In order to capture all of the costs incurred during a given accounting period, a firm will make estimates, called accruals, for all sorts of liabilities that are due to be settled in the future, whether utility bills, legal fees or big one-off costs. This creates an opportunity for creative directors. Here is a short example.
What you see here is a firm with a poor future profits profile (line 1) using accruals to create a much better one (line 4). Estimated costs are booked in year 1, which creates a profit reserve. If the cash is never spent, this can be released back to create a boost in year 3. In a stroke, a mediocre profit pattern becomes a much healthier one. Spotting this can be tricky but there is a number that can help. Enter the accruals ratio.

The accruals ratio

We will leave some of the mathematical and practical complexities to one side here, but in simple terms the ratio compares income from the profit and loss account (on an accruals basis) with the equivalent number from the cash flow statement, as a percentage of total assets. The smaller the answer the better.

A short example

Looking at the companies above, firm A has a ratio of 10%, whereas B’s is -4%. That makes B the better bet following this method, but why?
The answer depends on the outcome of a study by Richard Sloan at the University of Michigan. Looking at a 40 year period, he concluded that shares with high and positive accruals ratios under-performed those with lower, or negative, ones. The reason? Firms that rely heavily on accruals to boost profits in the short-term are more likely to disappoint later. And since investors are not very good at discerning which firms are which, this results in a disproportionately large sell-off when firms that are aggressive in their use of accruals duly underperform.

Does it still work now?

Recent studies have shown that, whilst the impact may be smaller than it once was, as more and more investors have woken up to the accruals risk, there are grounds for believing that the accruals ratio is still a useful differentiator. Why this should be, given that professional investors can, in theory, trade away (“arbitrage”) any advantage, is open to debate. It may be that timings such trades is tricky and the marginal costs of doing so outweigh the benefit in lower liquidity stocks of the type that tend to have higher accruals ratios.

That notwithstanding, be careful about placing too much reliance on a single ratio – broader screens that incorporate it are more likely to be reliable these days. Examples include the Piotrowski F-score, which looks at corporate strength and bankruptcy risk using a number of metrics.

Conclusion

The accruals ratio may no longer be the force it was in the mid-1990’s as a stock-picking tool now that investors are more savvy about the accruals risk and the accounting rules have removed some of the opportunities that used to exist for directors. However, any number that reminds investors of the importance of monitoring cash flow, every bit as much as reported earnings, should have a place in their toolbox.