Cash vs Accural

Do you recall the relationship between you and the canteen’s owner? Most of us used to make cash payments, but imagine if a considerable number of us began purchasing items on credit from the canteen—what do you think would happen? It’s evident that many individuals might default on their payments or seek out another canteen that offers credit facilities. This same challenge is prevalent among large corporations. Monitoring a company’s earnings becomes crucial in such scenarios. Those companies that opt for cash transactions today instead of extending credit tend to be financially stable and have demonstrated notable growth.

The industries such as FMCG (Fast-Moving Consumer Goods), franchises like McDonald’s and Burger King, and paint manufacturing businesses predominantly engage in cash transactions, in contrast to industries such as banking and B2B companies, which commonly offer credit to their customers. It’s imperative to comprehend the financial dynamics of the business in which we plan to invest our money.

As is well known, gross profits represent the variance between sales and the cost of goods sold. To calculate the net profit, accountants deduct other expenditures such as advertising costs, overheads, legal fees, etc., from the gross profit. Therefore, the quality of income is intricately linked to the quality of sales. The caliber of sales experiences an upswing when a significant portion of transactions occurs in cash rather than credit. In other words, cash earnings should surpass accrual earnings, underscoring the importance of the mode of transaction in influencing the overall financial health of a business.

To grasp these perspectives, delving into the psychology of people is essential. Extracting money from individuals involves navigating factors such as laziness, attitude, or morality, all of which significantly impact customers. Many have likely encountered the challenge of recovering money from even the closest friends, especially those to whom assistance was extended in times of need. Retrieving money under such circumstances proves challenging.

Now, envision a business extending a line of credit to thousands of customers. The complexities magnify. Businesses often make grand claims based on their accrual income, enticing investors with promises of substantial returns. Accounting standards further contribute to this scenario by allowing companies to document such accrual income in their financial statements, introducing the concept of accounts receivable (A/R) as a surrogate for cash.

The inevitable outcome is foreseeable. Customers default, leading companies to write off accounts receivable. Consequently, bad debts surge, dealing a blow to earnings. This intricate interplay between psychology, business practices, and accounting standards underscores the delicate nature of financial transactions and their potential ramifications.

It’s crucial to recognize that cash earnings and accrual earnings are not equivalent. This discrepancy has a cascading effect on the calculation of EPS (Earnings Per Share), subsequently distorting the P/E (Price/Earnings) ratio. Notably, revered investors like Graham and Dodd emphasized the importance of cash earnings, urging investors to place trust in cash flows.

Investors are advised to maintain a vigilant stance on sales and conduct comparisons of accrual sales with other companies within the same industry. One effective method for this analysis is the computation of Net Operating Assets (NOA) at the beginning and end of the year. An uptick in Net Operating Assets (End of Year NOA – Beginning of Year NOA) indicates that the increase in earnings is bolstered by a rise in accrual sales.

To calculate Net Operating Assets, use the following formula:

(CURRENT ASSETS – CASH) – (CURRENT LIABILITY – SHORT TERM LIABILITY – INCOME TAX PAYABLE)

This method serves as a valuable tool for investors aiming to discern the true financial health of a company, offering insights into the composition of earnings and potential red flags in the form of accrued sales.

This calculation signals the surplus of inventory and accounts receivables over accounts payables. For those finding this computation intricate, a rule of thumb is to remember: an increase in NOA implies that accrual sales surpass cash sales. Given that higher accrual sales often lead to write-offs, an escalating NOA suggests that earnings may not be sustainable, potentially resulting in a decline in cash flows in the upcoming years.

Historical trends reinforce the notion that companies with substantial accruals tend to be illiquid and volatile. This volatility is particularly evident in banking stocks compared to other industries. The 2008 financial crisis serves as a stark example. Banking institutions consistently reported rising incomes, masking the fact that they were extending bad loans to individuals lacking the creditworthiness to repay. The accumulation of such bad loans culminated in one of the most severe economic downturns in recent history.

Thus, a vigilant eye on cash flows is paramount. Investors are advised to stick to businesses they understand. If a company exhibits significant accrual earnings but remains incomprehensible, it’s prudent to abstain from investment. Opt for businesses that not only generate quality earnings but also boast strong cash flow—a strategy that aligns with sustainable and reliable investments.