High-quality earnings are backed by cash, come from the core business, are repeatable, and rest on conservative accounting. Low-quality earnings depend on accruals, one-time gains and optimistic estimates.
Accruals = net income minus CFO. Accruals ratio = (net income minus CFO) / average total assets. A large positive ratio means profit is running ahead of cash. Research by Richard Sloan (1996) found that companies with high accruals tended to underperform later.
The Beneish M-score combines eight ratios to flag possible earnings manipulation. The Altman Z-score combines five ratios to estimate bankruptcy risk for manufacturers; a score below about 1.8 signals distress and above about 3.0 signals safety. Both are screens that tell you where to look harder, not verdicts.
In several of these cases, warning signs on the checklist were visible in public filings before the collapse.
(1) Auditor's report and key audit matters. (2) Cash flow statement before the income statement. (3) Revenue recognition and significant estimates notes. (4) Debt, lease and contingency notes. (5) Non-GAAP reconciliation. (6) MD&A risk and liquidity sections. (7) Compare management's past promises with what happened.
The eight-variable model combines indexes that compare this year with last year:
| Variable | What it captures |
|---|---|
| Days sales in receivables index (DSRI) | Receivables growing faster than sales |
| Gross margin index (GMI) | Deteriorating gross margin, a pressure to manipulate |
| Asset quality index (AQI) | More costs capitalized as soft assets |
| Sales growth index (SGI) | Fast growth, which creates pressure and opportunity |
| Depreciation index (DEPI) | Slowing depreciation |
| SG&A index (SGAI) | Overheads growing faster than sales |
| Leverage index (LVGI) | Rising debt, closer to covenants |
| Total accruals to total assets (TATA) | Profit not backed by cash |
A score above about -1.78 is commonly read as a higher likelihood of manipulation. The model was built on 1980s and 1990s cases and produces many false alarms; treat it as a screen.
Last year DSO was 45 days; this year it is 60. DSRI = 60 / 45 = 1.33. Customers are taking a third longer to pay, or revenue is being booked before it can be collected. Values above about 1.3 are associated with manipulators in Beneish's sample.
| Company X | Company Y | |
|---|---|---|
| Net income | 120 | 100 |
| Operating cash flow | 40 | 130 |
| Cash conversion | 0.33 | 1.30 |
| Receivables growth | +45% | +6% |
| Revenue growth | +12% | +8% |
X reports more profit, but only a third of it arrives as cash and its receivables are growing nearly four times as fast as its sales. Y's lower profit is the more trustworthy figure. If X's pattern lasts more than a year or two, expect either a write-down of receivables or a need to raise money.
Managers can over-reserve in good years (for warranties, returns, restructuring or bad debts) and release the reserves in bad years to report steady profit. Steady earnings are not proof of steady business. Watch reserve balances as a percentage of the item they cover.
A change of auditor, especially after a disagreement; departures of the chief financial officer; a long-tenured auditor with large non-audit fees; a board without accounting expertise; management bonuses tied tightly to a single profit or EPS target. None proves anything, but each raises the value of reading the notes slowly.
Short sellers publish detailed reports on companies they believe are misreporting. Their incentives are obvious, but their evidence is checkable. Read any report against the filings and decide on the evidence, not the tone.
Run the 13-point checklist on one company you own or follow. Score one point per flag and write a half-page verdict.
Educational content only; not investment, tax or legal advice. Companies, tickers and figures are illustrative examples, not recommendations. Rules, rates and limits change, so check current details with the regulator, exchange or tax authority before relying on them. Worked examples are not forecasts. Written by Elizabeta Dimoska. RiskStock is not a registered dealer or adviser.