Your income statement says the business earned $141,000 last year. Your bank balance says otherwise. You paid income tax on every dollar of that profit, your accountant congratulated you on a 15% net margin, and yet the checking account barely moved — or dipped. Where did the money go?
Most owners stop at "growth eats cash" and move on. But there is a single number, borrowed from investment research, that turns that vague unease into a diagnosis. It is called the Sloan ratio, it takes about ten minutes to compute from statements you already have, and it answers a question every business owner should ask at least once a year: how much of my reported profit is actually cash, and how much is just accounting?
What the Sloan Ratio Measures
The Sloan ratio compares the profit your books report to the cash your business actually generated, scaled by the size of the business. The version popularized by stock-screening services looks like this:
Sloan ratio = (Net income − Cash flow from operations − Cash flow from investing) ÷ Total assets
Strip the investing term out and you get the simpler operating accrual ratio many analysts prefer for private companies:
Accrual ratio = (Net income − Cash flow from operations) ÷ Total assets
Either way, the logic is the same. Net income is an opinion shaped by accrual accounting — revenue you recognized but haven't collected, expenses you incurred but haven't paid, costs you capitalized instead of expensed. Cash flow is the reality. When the two diverge, the gap is called accruals, and the ratio measures how big that gap is relative to the business.
The conventional reading zones:
| Sloan ratio | What it usually means |
|---|---|
| Above +10% | Red flag. Profit is heavily accrual-driven; find out where the cash went. |
| −10% to +10% | Normal range. Accruals exist but are proportionate. |
| Below −10% | Cash is running well ahead of reported earnings. Usually a good sign — but check why. |
Those ±10% bands are rules of thumb from equity screening, not accounting law. What matters is the direction and the trend: a ratio that climbs from 3% to 9% to 16% over three years is telling you something even though only the last reading crosses the line.
The Research Behind It
The ratio is named for the accounting professor who, in a 1996 paper in The Accounting Review, documented what is now called the accrual anomaly. He split earnings into their cash and accrual components across thousands of companies from 1962 to 1991 and found two things.
First, accrual-driven earnings are less persistent than cash-driven earnings. A dollar of profit backed by a dollar collected from a customer tends to repeat next year. A dollar of profit that exists only because you booked a receivable tends to evaporate — receivables stretch, inventory sags, and the "earnings" reverse.
Second, people fixate on the headline number. Investors, lenders, and (critically for our purposes) business owners treat all profit as equal, and the market systematically overvalued accrual-heavy companies. A hedge strategy that bought low-accrual firms and shorted high-accrual ones earned roughly 10% a year over the sample period. Later analyses by the American Association of Individual Investors found the lowest-accrual stocks beat the market by around five percentage points annually.
You are not running a hedge fund. But the finding translates directly: when your own profit is accrual-heavy, you are the investor being fooled — by your own books. You make spending decisions, tax payments, and owner draws against earnings that haven't arrived as cash and may never arrive in full.
Why Owners Should Run It on Their Own Books
For a public company, the Sloan ratio is a tool for detecting aggressive accounting. For a privately held business, the stakes are different and arguably higher, because the same person prepares the statements and relies on them. Nobody is committing fraud — the danger is self-deception, and accrual accounting makes it remarkably easy.
Consider what lands in accruals in an ordinary small business:
- Revenue booked before collection. You finished the work in December, invoiced net-45, and recorded the income. Profit today, cash in February — maybe.
- Inventory you bought but haven't sold. Cash left the account; the P&L didn't notice.
- Prepaid expenses. The annual software renewal, paid upfront, sits on the balance sheet while its cost drips into the P&L month by month.
- Unbilled work in progress. Hours your team logged that you haven't invoiced yet.
- Capitalized costs. Equipment and build-outs that bypass the income statement entirely and hide in investing outflow.
Each one is legitimate accounting. Together, they can make a struggling business look healthy — and make you pay real cash taxes on profit you never received.
How to Calculate It: A Worked Example
Take a design agency doing $940,000 in revenue, up 22% after landing a large corporate account.
- Net income: $141,000 (a 15% margin)
- Depreciation and amortization: $10,000 (a non-cash expense)
- Accounts receivable: grew from $80,000 to $172,000 — the new client pays in 66 days instead of the old 38
- Prepaid expenses: up $5,000; accounts payable: up $2,000
- Cash flow from operations: $56,000
- Cash flow from investing: −$20,000 (new workstations and a small studio build-out)
- Total assets: $580,000
The operating cash flow isn't a guess — it reconciles: $141,000 profit, plus the $10,000 depreciation add-back, minus the $92,000 that went into receivables, minus $5,000 of prepaids, plus $2,000 of supplier credit.
Now the ratio:
(141,000 − 56,000 − (−20,000)) ÷ 580,000 = 105,000 ÷ 580,000 ≈ 18.1%
That is well above the +10% caution line. The simpler operating-only version, (141,000 − 56,000) ÷ 580,000, still lands at 14.7%. Either way, the verdict is the same: only about 40 cents of each profit dollar arrived as operating cash. The business is profitable and quietly bleeding into its own receivables.
Contrast a two-person software business charging subscriptions to credit cards: $120,000 of net income against $180,000 of operating cash flow, because customers pay annually upfront (deferred revenue grew $50,000) and card settlements clear in two days. With $210,000 of total assets and modest capex, the ratio comes out near −25% — cash running comfortably ahead of earnings. That is what healthy accrual structure looks like.
If You Don't Prepare a Cash Flow Statement
Many small businesses never produce an indirect-method cash flow statement. You can approximate the accrual gap with two balance sheets and the working-capital walk:
Accruals ≈ Δ Accounts receivable + Δ Inventory + Δ Prepaids + Δ Unbilled work − Δ Accounts payable − Δ Accrued liabilities − Δ Deferred revenue
Add back non-cash depreciation and compare the result to your net income. If receivables and inventory are absorbing more than the depreciation add-back returns, your Sloan ratio is positive and climbing.
Reading Your Own Number
A high ratio is not an accusation — it is a pointer. Walk the drivers in order:
- Is receivables growth faster than revenue growth? Revenue up 22% while AR more than doubled means the new business is being bought on credit — yours. Days sales outstanding is the number to track: revenue × DSO ÷ 365 should approximate your AR balance, and when DSO drifts from 38 days to 66, that drift is your missing cash.
- Is inventory turning over? Months of inventory on hand trending upward means cash is being converted into shelf-sitting stock. Slow-turning inventory is tomorrow's discount.
- What did you capitalize? A heavy equipment year will push the full Sloan variant up without anything being wrong — the capex-inclusive formula treats investing outflow as accrual-like. This is exactly why you should compute both versions: if the operating-only ratio is calm but the investing-inclusive one spikes, the story is capital spending, not phantom earnings.
- Is there a good reason? Deferred revenue growing means customers trust you with their cash upfront — that drives the ratio negative, which is the best kind of divergence.
A very negative ratio deserves one caution too. Cash ahead of earnings can mean deferred revenue and fast collections, or it can mean you've been stretching supplier payables. One is structural health; the other is borrowing from your vendors, and it reverses the moment they tighten terms.
What to Do When the Ratio Runs Hot
If your Sloan ratio is above +10% and the driver is receivables — the most common case for service businesses — the fixes are operational, not accounting:
- Change when you get paid, not just how much. Deposits at kickoff, milestone billing on long projects, and net-15 instead of net-45 terms on new contracts. The client who pays in 66 days was probably fine with 40 if you'd asked.
- Put teeth in collections. Late fees after a grace period, work that pauses on past-due invoices, and a hard stop at 60 days for new deliverables. An aging report you actually review weekly is worth more than any ratio.
- Credit-check the big accounts. One corporate client that stretches payments from 38 days to 66 days is doing more damage than a dozen small ones.
- Turn inventory. Set a turns target and mark down the tail. Cash that's been sitting on a shelf for nine months is an interest-free loan to nobody.
- Forecast before you celebrate. Run the next two quarters with accrual profit and cash receipts side by side. The gap between those two lines is your financing need — and knowing it in advance is the difference between a credit line on your terms and a scramble.
None of this changes your profit. All of it changes whether the profit is real.
The Limits of the Ratio
The Sloan ratio is a screening tool, not a verdict. Keep its limits in mind:
- One period can mislead. A single quarter-end receivable spike, a seasonal inventory build, or a lumpy prepayment can distort one reading. Compute it on trailing-twelve-month figures, and watch the trend more than the level.
- Growth is naturally accrual-heavy. A business adding revenue on credit terms will run a positive ratio during expansion. The question is whether the ratio stabilizes as you mature, or keeps climbing.
- Depreciation-heavy businesses skew negative. Depreciation is a non-cash expense that depresses net income but not cash flow, so shops full of machinery, vehicles, and equipment will show low or negative ratios without any virtue attached.
- It measures divergence, not cause. The ratio tells you cash and earnings disagree; only walking the balance sheet tells you why.
Run it annually at year-end and quarterly if your cash feels tighter than your profit says it should. It costs one coffee and it replaces the vague "where did the money go" feeling with a number you can act on.
Make Both Views of Your Books First-Class
The whole reason a ratio like this needs to exist is that most businesses keep one view of their finances — the accrual P&L — and treat cash as something to check separately. The healthiest setup makes both views first-class citizens: accrual profit for measuring performance, cash flow for surviving it, reconciled to each other continuously rather than reconstructed annually.
That is exactly how plain-text accounting works. Beancount.io keeps your books as readable, version-controlled text files where every accrual entry, receivable, and deferred-revenue balance is visible and auditable — no black boxes, no vendor lock-in, and both the accrual and cash pictures derive from the same single source of truth. Get started for free, dig into the documentation to see how double-entry tracking handles accruals, or see your ratios rendered live in Fava, the web dashboard that sits on top of a beancount ledger.
Profit is a story cash has to corroborate. The Sloan ratio is the fact-checker — run it on your own books before the bank does.