The term accruals to assets ratio refers to a measure that allows the investor-analyst to understand if the ratio of accruals to assets is changing over time. The accruals to assets ratio can detect if a company is changing an accounting practice to hide a solvency issue or bolster earnings.
Accruals to Assets Ratio = (∆ Working Capital - ∆ Cash - ∆ Depreciation) / ∆ Total Assets
Capital structure and solvency measures allow the investor-analyst to understand the company's ability to remain in business in the long term. This is usually assessed by examining the relationship between debt, equity and the proportions of different types of stock. Solvency is the ability to continue operating, which oftentimes depends on cash flow. One of the ways to understand the overall solvency position of a company is by calculating their accruals to assets ratio.
The accruals to assets ratio provides the investor-analyst with information in terms of the possibility a company has changed an accounting practice and they are making this change to improve the view of their financial results. The ratio needs to be examined over time to detect a change, and a sudden increase in a historical trend may indicate an attempt to cover up a financially-stressed business.
The accrual to asset ratio assumes the proportions of assets appearing on the balance sheet should remain relatively stable. This is true if the nature of the company's business remains the same over time. However, this assumption is not always correct and the investor-analyst must be aware of this possibility before drawing conclusions.
The manager of a large mutual fund believes Company ABC has changed an accounting practice which is manifesting itself in higher profits. The manager would like to validate this hunch and asks his analytical team to calculate the company's accrual to asset ratio over time. The team gathered information for the last three years, which appears in the tables below:
|Year 1||Year 2||Change|
The accrual to asset ratio would be calculated as:
= ($2,381,538 - $335,995 - $62,500) / $2,500,000
= $1,983,043 / $2,500,000, or 79%
|Year 2||Year 3||Change|
For this second period, the accrual to asset ratio would be calculated as:
= ($1,428,923 - $70,559 - $31,250) / $1,375,000
= $1,327,114 / $1,375,000, or 97%
Given the sharp increase in the accrual to assets ratio, the fund manager decided to sell the shares of Company ABC's common stock held in his fund.