Not All Earnings are Created Equal: Follow the Cash

One of my favorite sayings comes from Aesop’s hawk and nightingale fable. A hawk captures a nightingale and is about to eat it when the nightingale, fighting for its life, tries to convince the hawk otherwise. The nightingale argues that it is too small of a bird to satisfy the hawk’s appetite and the hawk would be better off capturing larger birds. The hawk replies:

I should indeed have lost my senses if I should let go food ready in my hand, for the sake of pursuing birds which are not yet even within sight.

Cash is King

The lesson of the story is summed up in the saying “A bird in the hand is worth two in the bush.” Leave it to Ancient Greece to give us one of the most important lessons in investing. I’ve used this saying to explain why dividend-paying stocks should be an important part of your portfolio and I’m using it again today to argue that a company’s cash flow from both operations and investments is more important than its earnings. To hear this may shock you because the media always touts earnings as the quintessential measure of a company’s financial performance.

Accounting 101

Under generally accepted accounting principles (GAAP), the definition of earnings is the change in owner equity plus dividends (if any). Earnings are shown on the company’s income statement, which is nothing more than a measurement of the change between balance sheet items. As legendary value investor Ben Graham wrote in his equally-legendary investment book Security Analysis:

The meaning of any income statement cannot properly be understood except with reference to the balance sheet at the beginning and the end of the period.

Since owner equity is equivalent to assets minus liabilities, earnings can also be thought of as the change in net assets (i.e., change in assets minus change in liabilities). Liabilities are by definition not cash and there are many different non-cash assets (e.g., inventory and accounts receivable). Consequently, earnings often differ markedly from cash flow.

Earnings Can Be Manipulated

There is a lot of room for accounting discretion when dealing with non-cash assets. For example, a retailer that sells $110 worth of clothes on credit has to decide whether to book sales for the full $110 or book a lower number to take into account the likelihood of customer returns. Similarly, a company with work-in-process inventory has some leeway in valuing that inventory — the higher the valuation, the higher the earnings now. If customer merchandise returns come in higher than provisioned for, or inventory is sold for less than its stated value, future period earnings will take a hit.

On the liability side, there is significant discretion in how to book cash outflows – as current period expenses or later period capital investments. The more that cash outflows are capitalized, the higher a company’s earnings will be in the current period and the lower they will be in future periods (since the investments will need to be systematically depreciated, which is an expense).

The bottom line is that unusually high accruals now due to aggressive accounting will maximize current earnings but by necessity will result in lower earnings later (assuming no growth in earnings). The corollary is that unusually low accruals now due to conservative accounting will minimize current earnings but result in higher earnings later.

Cash Flow Isn’t Perfect Either

On the other hand, cash is, well, cash and there is no room for subjectivity (absent fraud). That’s the good news. The bad news is that cash flows can be very lumpy and not indicative of the continuous liabilities they are associated with. For example, if a health club collects a two-year membership fee up front in cash, the cash will all show up in the current year, making the company look more profitable than it really is given that the cash is tied to a service obligation that lasts for two years. The reason GAAP accounting exists is to help match a company’s assets with its liabilities in a more relevant way that demonstrates the true profitability of the company.

Accrual Earnings or Cash Flow, That is the Question

So, that background sets up the dilemma. GAAP accrual accounting is more relevant to assessing corporate performance but subject to inaccurate estimation, whereas cash accounting is somewhat less relevant to corporate performance but is much more accurate.

The difference between earnings and cash flow is called “accruals.” The equation is simply:

Accruals = Earnings – Cash Flow from Operations – Cash Flow from Investing

Professor Richard Sloan and Accrual Ratios

Enter UC-Berkeley accounting professor Richard Sloan. He’s written a number of academic papers comparing the future 12-month stock performance of companies that report earnings with a high degree of accruals versus companies that report earnings with a lower degree of accruals (i.e., earnings closer to, or even below, cash flow). Specifically, he measures the degree of a company’s accruals by an “accrual ratio,” which divides total accruals by the company’s net operating assets (NOA). NOA equals non-financial assets minus non-financial liabilities, which is a form of invested capital. The NOA calculation is a bit difficult so you can use total assets as an approximation.

Sloan’s conclusion is that companies with low accrual ratios outperform companies with high accrual ratios. In fact, for the 40-year period between 1962 and 2001, buying the lowest accrual companies and shorting the highest accrual companies resulted in an average annual compounded return of 18%, more than double the S&P 500’s 7.4% annual return over the same period.

Most Investors are Lazy and Don’t Analyze Financial Statements

Professor Sloan’s rationale for this outperformance is that investors are naïve, making their investment decisions on earnings alone without taking into account the composition of those earnings. They value the earnings of a high accrual company just as highly as the same earnings of a low accrual company, even though the high accrual company’s earnings are more likely to reverse in future years. When future earnings reverse, investors are “surprised” and sell off the stock causing the stock price to decline. Similarly, when a low accrual company’s earnings accelerate in future years, they are surprised in a good way and bid up the stock price.

Well, dear readers, you no longer need to be naïve and surprised. I ran a screen on my trusty Bloomberg terminal for stocks with low and high accrual ratios. The low ones may be good buys and the high ones may be sells (further research is required). Keep in mind that Sloan’s performance numbers are based on averages. Not every individual stock that met his accrual ratio criteria performed as expected.

Low Accrual Ratios (Potential Buys)



Cash Flow from Operations

Cash Flow from Investing


Total Assets

Accrual Ratio


Cypress Semiconductor (NasdaqGS: CY)

$92 million

$265 million

$40 million

-$213 million

$762 million



Automatic Data Processing (NYSE: ADP)

$1.37 billion

$1.90 billion

$8.57 billion

-$9.1 billion

$39.38 billion


Payroll Processing

Motorola Solutions (NYSE: MSI)

$818 million

$649 million

$2.31 billion

-$2.14 billion

$12.4 billion


Communications Equipment

Marriott International (NYSE: MAR)

$201 million

$1.08 billion

-$204 million

-$670 million

$6.17 billion



H&R Block (NYSE: HRB)

$338 million

$635 million

$250 million

-$547 million

$4.85 billion


Tax Preparation

High Accrual Ratios (Potential Sells)



Cash Flow from Operations

Cash Flow from Investing


Total Assets

Accrual Ratio


Endeavor International (NYSE: END)

$-159 million

-$45 million

-$649 million

$535 million

$1.40 billion


Oil & Natural Gas Exploration

Colfax Corp. (NYSE: CFX)

-$108 million

-$57 million

-$1.72 billion

$1.67 billion

$6.13 billion


Industrial Machinery

Lions Gate Entertainment (NYSE: LGF)

-$37 million

-$163 million

-$552 million

$679 million

$2.79 billion


Movie Production & Theaters

Clean Energy Fuels (NasdaqGS: CLNE)

-$70 million

$-36 million

-$175 million

$142 million

$927 million


Natural Gas Transportation Fuel

Tesla Motors (NasdaqGS: TSLA)

-$295 million

-$121 million

-$265 million

$91 million

$761 million


Auto Manufacturing

Source: Bloomberg