How to probe for profits with the 'M score'

When you are weighing up a potential investment, profits are likely to play a big part in your decision. So when you look at the profits figure in a company's annual report, you need to have confidence that the figure is accurate.

Now, the good news is that accounting standards are a lot more rigorous than they used to be. Thus, in most cases, you can believe in the profits that companies report. That said, there is still scope for some firms to bend the rules and deceive people.

If you can spot a company that is manipulating its profits, that could save you a lot of pain later on. The market will eventually realise that profits aren't as big as the company claimed, and the share price will probably fall.

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You might also decide to short' a company that has been overstating its profits. In other words, you can bet on its share price falling.

Back in the late 1990s, Messod Beneish of Indiana University produced a mathematical model to highlight companies that might be fiddlingtheir profit figures. The model uses

eight different financial ratios.

Beneish created an index for each of the eight ratios and added them all together to come up with something known as the M-Score. An M-Score within a particular range is a sign of potential profit manipulation.

What is the M-Score?

The M-Score places a heavy emphasis on accounting accruals remember, companies often recognise revenues that have been earned, but where the cash hasn't yet been paid. The M-Score also looks at expenses that have been incurred but not yet paid for.

The eight different indices are based on changes in the eight selected accounting ratios from one year to the next. Below are the eight indices.

DSRI (days' sales in receivables index): This looks at the number of sales made on credit but not received as cash. Companies can appear to be growing very quickly if they offer more generous credit terms.

To calculate the index, take accounts receivable/sales for the current year and divide it by the same number for the year before. A number greater than one might indicate that revenues are being inflated, although there might be another more innocent explanation.

GMI (gross margin index): Gross profit is defined as sales less the cost of goods sold. Here, take the gross profit margin for the previous year and divide it by the same margin for the currentyear. If gross margin has fallen, the index will be greater than one and that indicates poor prospects. This might encourage a company to manipulate its profits.

AQI (asset quality index): This index can help you spot companies that may be deferring costs by capitalising some costs on the balance sheet instead of incurring them normally as a conventional cost. (In other words, the cost is seen as an investment' that has created a new asset.)

The index looks at the ratio of non-current assets excluding property, plant and equipment as a proportion of total assets. That's then compared to the same ratio for the previous year. A number greater than one might indicate that a company is doing something dodgy.

SGI (sales growth index): Divide current sales by last year's sales. If the ratio is well above one, sales are rising fast. Companies with rapid sales growth are more likely to manipulate profits.

DEPI (depreciation index): This looks at whether the company is writing down the value of its assets fast enough (depreciation). A number greater than one suggests that a company might be artificially boosting profits by reducing

its depreciation.

SGAI (sales, general and administrative expenses index): This looks at the change in the SG&A expense as a percentage of sales compared with last year. If the index is greater than one it might be seen as a sign of deteriorating prospects.

TATA (total accruals to total assets index): Accruals are defined as working capital less cash(current assets less cash minus current liabilities). Higher accruals are often associated with potential profit manipulation.

LVGI (leverage index): This measures the ratio of total debt to assets compared with the previous year. An increase might signal profit manipulation.

Calculating the M-Score

Beneish uses all of these indices to calculate the M-Score. If the score is greater than -2.22 (a less negative number), that may be a sign that the company's profits have been manipulated. Further investigation is warranted.

If you want to calculate the M-Score yourself, here is the formula:

M-Score = -4.84 + 0.92DSRI + 0.528GMI + 0.404AQI + 0.892SGI +0.115DEPI - 0.172SGAI +4.679TATA - 0.327LVGI.

How the M-Score predictedtrouble at Enron

Calculating the M-Score for Enron between 1999 and 2000 gave a figure of -0.55 that indicated that Enron might be manipulating its profits. This was proved to be the case in 2001.