Beneish M Score - A Effective Credit Evaluation Tool for Credit Assessment
Jay Ranvir
Leasing -Commercial Vehicles, EV, Construction Equipment, Industrial P & M, Rooftop Solar, Insolvency Professional, Author, Govt Approved Valuer, Forensic Accounting and Fraud examiner
The Beneish M-Score is a mathematical model that uses eight financial ratios to identify whether a company has manipulated its earnings. Earnings manipulation is a strategy used by the management of a company to deliberately misrepresent the company's financial condition. This is often done to make the company appear more profitable than it actually is. The Beneish M-Score helps to identify such companies, thus assisting investors in making informed decisions.
The Beneish M-Score is a valuable tool for investors, financial analysts, and auditors. It provides a quantitative measure of a company's likelihood of having manipulated its earnings, which can inform investment decisions and audit planning.
Understanding the Beneish M-Score
The Beneish M-Score is calculated using eight financial ratios. These ratios are derived from the company's financial statements and are used to measure various aspects of the company's financial performance. The ratios are then weighted and summed to produce the M-Score.
The eight ratios used in the Beneish M-Score are: Days Sales in Receivables Index (DSRI), Gross Margin Index (GMI), Asset Quality Index (AQI), Sales Growth Index (SGI), Depreciation Index (DEPI), Sales, General and Administrative expenses Index (SGAI), Leverage Index (LVGI), and Total Accruals to Total Assets (TATA).
M-SCORE = ?4.84 + 0.92 × DSRI + 0.528 × GMI + 0.404 × AQI + 0.892 × SGI + 0.115 × DEPI ?0.172 × SGAI + 4.679 × TATA ? 0.327 × LVGI
DSRI: Days Sales in Receivables Index
This compares the ratio of receivables to sales in the most recent fiscal year to the same ratio in the previous fiscal year. The ratio of receivables to sales is basically the percentage of sales for which cash has not yet been received. If that ratio is getting a lot bigger, it’s a sign that the company may be overstating its sales
Days Sales in Receivables Index (DSRI) =
(Net Receivables t?/ Sales t)
______________________________________
Net Receivables t-1?/ Sales t-1)
DSRI Result interpretation:
A DSRI greater than 1 suggests that the company's receivables are growing faster than its sales, which could indicate aggressive accounting tactics, such as recognizing revenue prematurely, or a deterioration in the company's economic conditions. It may also be a sign that the company is offering more generous credit terms to customers to boost sales.
On the other hand, a DSRI below 1 implies that the company's receivables are decreasing relative to its sales. While this may seem positive, it could also be a warning sign, indicating that the company is resorting to desperate measures to increase sales, such as extending credit to customers with poor credit histories or engaging in "channel stuffing."
Channel stuffing, also known as trade loading, is a business practice in which a company, or a sales force within a company, inflates its sales figures by forcing more products through a distribution channel than the channel is capable of selling
When evaluating a company's DSRI, it's also important to be aware that certain practices, such as?factoring?or securitizing receivables, can distort the ratio's usefulness. In these cases, it may be necessary to adjust the data to account for these practices and gain a more accurate understanding of the company's financial situation.
GMI: Gross Margin Index
This compares the company’s gross margin in the previous fiscal year to the company’s present gross margin. If a company’s gross margin is markedly deteriorating, that gives it a strong incentive to manipulate its financials
Gross Margin Index (GMI) =
((Sales t-1 - Cost of Goods Sold t-1) / Sales t-1))
______________________________________________________________________ ((Sales t - Cost of Goods Sold t) / Sales t) )
The cost of goods sold (COGS) is the sum of all direct costs associated with making a product. It appears on an income statement and typically includes money mainly spent on raw materials and labour. It does not include costs associated with marketing, sales or distribution.
COGS includes costs such as raw materials and labour that vary depending on the amount of product you produce. It doesn’t include indirect costs that the business incurs regardless of how much is produced—for example, office expenses, administrative salaries or marketing costs.
GMI Result interpretation:
A GMI greater than 1 indicates that the company's gross margins have decreased compared to the previous year, which could be a warning sign, suggesting that the company is facing challenges in maintaining its profitability. This deterioration in gross margin may be due to the company struggling to control its costs or maintain its pricing power in the market.
On the other hand, a GMI significantly lower than 1 implies that the company's gross margins are increasing dramatically. While this may seem positive at first glance, it can also be a cause for concern, as it may indicate that the company is engaging in manipulative practices to inflate its financial performance.
Companies with declining or rapidly increasing gross margins may be more likely to engage in earnings manipulation to make their financial performance appear better than it actually is. Therefore, the GMI is included in the Beneish model to help identify potential red flags in a company's financial statements.
AQI: Asset Quality Index
The?Asset Quality Index (AQI)?is a financial ratio that measures the proportion of a company's total assets composed of assets with potentially uncertain future benefits.
This takes the company’s non-current assets that are not in net plant, property, and equipment, divides that by its total assets, and compares that number to that of the previous fiscal year.
Asset Quality Index (AQI) =
(1 - ((Current Assets t?+ PPE* t) / Total Assets t))
_________________________________________________________________
(1 - ((Current Assets t-1?+ PPE t-1) / Total Assets t-1))
*PPE - Property, Plant and Equipment
An AQI greater than 1 indicates that the company's noncurrent assets, such as goodwill, intangibles, and other items with uncertain long-term value, are growing as a percentage of total assets compared to the previous year. This increase in the proportion of assets with uncertain future benefits may indicate a higher risk of earnings manipulation.
A higher AQI could be the result of excessive capitalization of expenses (meaning the recording of costs as assets on the balance sheet, delaying their impact on the income statement) or a sign of deteriorating fundamentals at the company. The further AQI is above 1, the more these intangible assets have grown compared to the more tangible current assets.
However, it's important to note that a high AQI could also be the result of substantial acquisitions (since acquisitions can increase non-current assets relative to total assets, raising the AQI), although Beneish points out that firms prone to manipulation usually engage in minimal acquisition activities:
Manipulators undertake few acquisitions and those are primarily stock-for-stock exchanges accounted for using pooling of interest.
This means that firms known for financial manipulation rarely engage in acquisitions. When they do, they typically use their stock for transactions and adopt a "pooling of interests" method. This avoids revaluing assets and liabilities, helping to conceal financial weaknesses and reduce impacts on reported profits.
In essence, the AQI depends on the balance between current assets, net plant, and total assets. If one or two of these components change radically from one year to the next, it can be a significant warning sign that merits close consideration, even in the absence of reverse mergers and acquisitions.
Manipulators undertake few acquisitions and those are primarily stock-for-stock exchanges accounted for using pooling of interest.
This means that firms known for financial manipulation rarely engage in acquisitions. When they do, they typically use their stock for transactions and adopt a "pooling of interests" method. This avoids revaluing assets and liabilities, helping to conceal financial weaknesses and reduce impacts on reported profits.
In essence, the AQI depends on the balance between current assets, net plant, and total assets. If one or two of these components change radically from one year to the next, it can be a significant warning sign that merits close consideration, even in the absence of reverse mergers and acquisitions
AQI Result interpretation
AQI > 1:
Sales Growth Index (SGI)
This is a simple measure of sales growth from the most recent fiscal year to the previous one. High-growth firms are more likely to engage in financial statement fraud. (ie Ratio of Revenue (Sales) in year t to Revenue (Sales) in previous year t-1.)
Sales Growth Index (SGI) =
Sales t?
__________________
Sales t-1
SGI Result interpretation:
An SGI greater than 1 indicates that the company's sales have increased compared to the previous year. The higher the SGI is above 1, the greater the growth in sales.
While sales growth is generally viewed as a positive by investors, high growth companies may be more likely to manipulate their earnings, especially if they're facing a potential slowdown. This is because their financial position and capital needs put pressure on managers to achieve earnings targets, and they may face large stock price losses at the first indication of a slowdown, creating greater incentives to manipulate earnings.
Therefore, when a company with high sales growth also scores poorly on other variables in the Beneish model, it could be a significant red flag for potential financial statement fraud. However, it's important to note that high sales growth alone does not necessarily imply manipulation; it's the combination of high growth and other warning signs that should raise concerns.
High sales growth itself does not mean of earnings manipulation, however, high growth companies are more likely to commit financial fraud in order to keep up the appearance of high sales.
DEPI: Depreciation Index
The?Depreciation Index (DEPI)?is a financial ratio that compares a company's depreciation rate in the current year to the rate in the previous year.
Depreciation Index (DEPI) =
(Depreciation t-1?/ (Depreciation t-1?+ PPE t-1))
_________________________________________________________________________________________
(Depreciation t?/ (Depreciation t?+ PPE t))
A DEPI greater than 1 indicates that the company's depreciation rate has decreased compared to the previous year. The higher the DEPI is above 1, the more the depreciation rate has slowed down. This suggests that the company may have revised its estimates of assets' useful lives upwards or adopted a new depreciation method that results in higher reported income.
The DEPI is included in the Beneish model to capture potential manipulation of depreciation to inflate earnings. By increasing its estimates of asset useful lives or adopting a new income-increasing method, a company can slow down the recognition of expenses, potentially artificially boosting its reported income.
DEPI > 1:
领英推荐
Income increases due to adjusting depreciation methods; i.e., the company revises upwards the estimates of assets useful lives. In such a way, company may increase income by cutting expenses.
SGAI: Sales General and Administrative Expenses Index
SGAI?is a financial ratio that measures the change in a company's SG&A expenses as a percentage of sales compared to the previous year.
Sales, General and Administrative Index (SGAI) =
(SG&A Expense t?/ Sales t)
___________________________________
(SG&A Expense t-1?/ Sales t-1)
An SGAI greater than 1 indicates that the company's SG&A expenses have increased as a percentage of sales compared to the previous year, which could be a sign of declining administrative and marketing efficiency. The higher the SGAI is above 1, the more SG&A expenses have grown relative to sales.
The SGAI is included in the Beneish model to capture potential manipulation of SG&A expenses to boost earnings.
A disproportionate increase in sales compared to SG&A expenses (i.e., SGAI < 1) could be interpreted as a negative signal about a company's future prospects, as it may indicate that sales are overstated. Public companies facing deteriorating operational performance may be more likely to engage in earnings manipulation to mask their challenges.
On the other hand, a substantial increase in SG&A expenses without a corresponding increase in sales (i.e., SGAI > 1) could also be a warning sign, as it may suggest that managers are being paid excessively or that the company is experiencing declining administrative and marketing efficiency, which could motivate managers to manipulate earnings.
SGAI Result interpretation:
SGAI > 1:
LVGI: Leverage Index
LVGI?is a financial ratio that compares a company's total debt to total assets in the current year to the previous year.
This compares the ratio of total debt to total assets between the most recent two fiscal years. If debt is rising, there’s more incentive for earnings manipulation.
Leverage Index (LVGI) =
((Long-Term Debt t?+ Current Liabilities t) /Total Assets t)
____________________________________________________________________
((Long-Term Debt t-1?+ Current Liabilities t-1) / Total Assetst-1)
An LVGI greater than 1 indicates that the company has become more leveraged compared to the previous year. The higher the LVGI is above 1, the more the company's leverage has increased, suggesting that the company may be under pressure to meet debt covenants or raise additional capital.
Companies facing financial pressure may be more likely to manipulate their earnings. As a company becomes increasingly leveraged, it tightens its debt constraints and may be more predisposed to manipulate its earnings to meet obligations or maintain access to capital.
LVGI Result interpretation:
LVGI > 1:
?However, it's important to note that a decrease in the LVGI (i.e., LVGI < 1) could also be a warning sign. While a company with a declining LVGI might be paying off its debts, it could also be increasing its equity by selling a large number of shares.
TATA: Total Accruals to Total Assets
TATA?ratio measures the extent to which a company's reported earnings are backed by cash.
This ratio does?not?compare the most recent two fiscal years, but simply takes accruals and divides by total assets.
"Accruals" represent the difference between a company's accounting profit (or loss) and its cash profit (or loss), which is then divided by total assets to make the variable comparable across companies of different sizes.
?Total Accruals to Total Assets (TATA) =
(Income Before Extraordinary Items t?- Cash From Operations t)
________________________________________________________________________
Total Assets t
TATA Result interpretation:
Increasing accruals as part of total assets:
Thus, calculations are made separately for each of these eight financial ratios first. These variables are then combined together to achieve an M-Score for the company.
8-Variable Beneish M-Score =
-4.84 + (0.92 × DSRI) + (0.528 × GMI) + (0.404 × AQI) + (0.892 × SGI) + (0.115 × DEPI) - (0.172 × SGAI) + (4.679 × TATA) - (0.327 × LVGI)
Positive coefficients (DSRI, GMI, AQI, SGI, DEPI, TATA) indicate that an increase in the corresponding variable leads to a higher probability of earnings manipulation, while negative coefficients (SGAI, LVGI) suggest that an increase in the corresponding variable decreases the probability of earnings manipulation. The magnitude of each coefficient represents the relative importance of the corresponding variable in predicting earnings manipulation.
The coefficient for TATA (4.679) is the largest in absolute value, indicating that total accruals to total assets is the most influential variable in the model. In contrast, the coefficient for DEPI (0.115) is relatively small, suggesting that the depreciation index has a lesser impact on the M-Score compared to other variables.
Individual Variable Interpretations
The interpretations of individual variables were explained prior, but you can also refer to the table below to examine whether each variable suggests that a company is a potential manipulator or not:
BENEISH M-SCORE RESULT INTERPRETATION:
The Beneish M-Score is a valuable tool for investors, financial analysts, and auditors. It provides a quantitative measure of a company's likelihood of having manipulated its earnings, which can inform investment decisions and audit planning.
However, like any tool, the M-Score is not without its limitations. It is based on historical financial data and is subject to statistical error. Therefore, it should be used in conjunction with other tools and techniques for detecting earnings manipulation
Limitations of the Beneish M-Score
Dependence on Historical Data
One of the main limitations of the M-Score is that it is based on historical financial data. This means that it may not be able to detect recent or ongoing instances of earnings manipulation.
If the financial data is inaccurate or incomplete, the M-Score may not be reliable.
It may not be able to detect recent or ongoing instances of earnings manipulation. For example, if a company has recently started manipulating its earnings, this may not be reflected in the M-Score.
Statistical Error
The Beneish M-Score is a statistical model, which means that it is subject to statistical error. This means that the M-Score may produce false positives (i.e., indicating that a company has manipulated its earnings when it has not) or false negatives (i.e., failing to indicate that a company has manipulated its earnings when it has).
This limitation can be mitigated to some extent by using the M-Score in conjunction with other tools and techniques for detecting earnings manipulation. For example, the M-Score could be used in combination with a detailed analysis of the company's financial statements and a review of the company's internal controls along with other financial ratios.
Exclusion of Financial Services: The M-Score does not apply to financial firms such as banks and insurance companies.
Lack of Contextual Information: The model focuses solely on quantitative financial data and does not consider qualitative factors like management integrity or corporate governance, which can be necessary for a comprehensive evaluation