Beneish M-Score definition
The Beneish M-Score is a mathematical model used for the identification of possible manipulations in company earnings.
What is the Beneish M-Score?
The Beneish M-Score was introduced by Professor Messod Beneish in a paper in 1999 as a mathematical model for the evaluation and identification of manipulations in earnings made by the companies.
The model considers eight financial variables calculated using information from the company's financial statements. These variables are then weighted with a pre-specified coefficient in the process of estimating the degree of manipulation with regard to the company earnings.
The equation for the calculation of the Beneish M-Score, consisting of the variables and coefficients respectively, is:
Beneish M-Score = -4.840 + 0.920 x DSRI + 0.528 x GMI + 0.404 x AQI + 0.892 x SGI + 0.115 x DEPI - 0.172 x SGAI - 0.327 x LVGI + 4.697 x TATA
Beneish M-Score explained
Probable manipulations in company earnings can be identified in the financial data reported by the company. This data is represented in eight variables, where each serves to measure a particular activity. The eight financial ratios are:
Days' sales in receivables index (DSRI) – refers to possible revenue inflation measured through the ratio of day's sales in receivables compared to last year.
Gross margin index (GMI) – evaluated as the gross margin versus the prior year. It is expected that a company with a worsening financial performance stands a higher chance of manipulating financial earnings.
Asset quality index (AQI) – ratio of non-current assets (excluding plant, property and equipment) to total assets in comparison to the previous year.
Sales growth index (SGI) – represents the ratio of sales versus the sales achieved in the previous year.
Depreciation (DEPI) – accounts for the ratio of the rate of depreciation compared to the previous year’s rate.
Sales, general and administrative expenses (SGAI) – ratio composed of these expenses versus the previous year’s expenses.
Leverage index (LVGI) – considers the ratio of total debt to total assets in relation to the previous year.
Total accruals to total assets (TATA) – ratio representing changes in working capital (less depreciation) to total assets compared to the previous year.
The different ratios included in the calculation of Beneish M-Score serve the purpose of evaluating different aspects of the company's operations. Through the ratio, investors and analysts account for possible modifications in revenues, sales levels, changes in depreciation, changes in expenses, etc. The inclusion of different variables offers a more precise evaluation of financial statements.
Companies with a higher Beneish M-Score value are more likely to be manipulators. A Beneish M-Score below -2.22 indicates that company earnings are not manipulated; a value above -2.22 indicates that the company is a potential manipulator.