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How do you calculate the Beneish M-score for a borrower?

The M-score does not prove manipulation, but it tells a lender which lines of a borrower's earnings to test first.

Julian R. Sterling · from Credit Analysis

The Beneish M-score combines eight ratios from two consecutive years of accounts: M = −4.84 + 0.920 DSRI + 0.528 GMI + 0.404 AQI + 0.892 SGI + 0.115 DEPI − 0.172 SGAI + 4.679 TATA − 0.327 LVGI. A score above −1.78, the cut-off in Beneish's 1999 paper, or above the more cautious −2.22 many analysts use, flags a higher likelihood that earnings have been overstated. The illustrative borrower below scores −1.63, above both cut-offs, driven mainly by receivables growing faster than sales.

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For a lender the M-score is a screen, not a verdict. It does not say that a borrower has manipulated its accounts; it says that the pattern of its last two years resembles the pattern of companies that did, and that the EBITDA in the credit paper deserves a harder look before anyone lends against it.

The assumptions

An illustrative borrower, figures in millions. No marketable securities.

Line	Prior year	Current year
Sales	200.00	236.00
Trade receivables	30.00	45.00
Gross profit	80.00	87.32
Current assets	90.00	112.00
Net property, plant and equipment	70.00	74.00
Total assets	190.00	236.00
Depreciation	10.00	9.00
SG&A	36.00	40.00
Current liabilities	50.00	60.00
Long-term debt	60.00	80.00
Income from continuing operations		20.00
Cash flow from operations		8.00

The calculation, step by step

Contribution of each index. A neutral company has every index at 1 and TATA at 0.

Index	Value	Coefficient	Contribution	Above neutral
DSRI	1.271	0.920	1.17	0.25
GMI	1.081	0.528	0.57	0.04
AQI	1.342	0.404	0.54	0.14
SGI	1.180	0.892	1.05	0.16
DEPI	1.153	0.115	0.13	0.02
SGAI	0.942	−0.172	−0.16	0.01
TATA	0.051	4.679	0.24	0.24
LVGI	1.025	−0.327	−0.34	−0.01
M-score, with the −4.84 constant			−1.63

The result

The borrower scores −1.63, 0.15 above the −1.78 cut-off. The useful reference point is the neutral company: one whose ratios did not move and whose profit equals its operating cash flow scores −2.48. The "above neutral" column therefore shows where the 0.85 between −2.48 and −1.63 comes from, and three items do almost all the work:

• Receivables, 0.25. Sales grew 18 per cent, receivables 50. Had receivables kept pace they would be 35.4, so 9.6 of this year's sales had not turned into cash at the year end.
• Accruals, 0.24. Profit of 20 against operating cash flow of 8: 12 of the reported profit is accrual.
• Sales growth and soft assets, 0.16 and 0.14. Growth itself raises the score, because fast growers face more pressure to keep it up, and the 20 increase in other assets is what capitalising costs looks like.

Read it against the EBITDA bridge. A high M-score on a borrower whose credit case rests on management add-backs is the combination that matters. The score points at receivables and capitalised costs; those are exactly the lines a quality-of-earnings review should test before the leverage ratio is agreed.

What would bring the score down?

Mechanical variants, all other inputs unchanged.

Variant	M-score
As reported	−1.63
Operating cash flow equal to profit, 20	−1.87
Receivables in line with sales at 35.4, the 9.6 collected so cash flow is 17.6	−2.07
Other assets held at 30, with 20 less long-term debt	−1.77
All three: receivables at 35.4, cash flow of 20, other assets at 30	−2.28

No single fix takes the borrower below −2.22; normalising receivables comes closest, because it moves both DSRI and accruals. Holding everything else, operating cash flow would need to reach 15.5 to bring the score to −1.78 and 37.7 to reach −2.22, almost twice reported profit.

The common mistakes

• Treating the cut-off as a pass mark. The model was estimated on a sample of manipulators and controls; it misclassifies in both directions. A score of −1.63 is a reason to ask questions, and a score of −2.50 is not a clean audit opinion.
• Running it across an acquisition. Bought-in sales lift SGI, acquired receivables lift DSRI and goodwill lifts AQI, so a borrower that bought a business scores high for reasons that have nothing to do with its accounting. Use pro forma prior-year figures or set the score aside for that year.
• Using it on banks and insurers. Their balance sheets have no meaningful current/non-current split or gross margin, and the indices lose their meaning.
• Using EBITDA instead of income from continuing operations in TATA. EBITDA minus operating cash flow is mostly interest, tax and working capital, not accruals, and overstates the term.

Takeaway

Compute the eight indices, multiply by the coefficients, and compare the result with −2.48, −2.22 and −1.78 rather than with one line. Here the borrower's −1.63 is mostly receivables and accruals, which tells the analyst which part of the earnings to test. How the same borrower can show four different EBITDAs, and what each does to leverage, is in the free workbook for this case and in what an EBITDA add-back bridge is actually worth.

Questions readers ask

What is a good Beneish M-score?

Lower is better. Beneish's 1999 paper used -1.78 as the cut-off, and many analysts use the more cautious -2.22. A useful anchor is the neutral company, whose ratios did not change and whose profit equals its cash flow: it scores -2.48. The illustrative borrower scores -1.63, so it sits 0.85 above neutral and above both cut-offs.

Which Beneish ratio matters most?

It depends on the company, but TATA carries by far the largest coefficient, 4.679, and DSRI is weighted 0.920. For the illustrative borrower, receivables growing 50 per cent against 18 per cent sales growth add 0.25 to the score above neutral and accruals of 12 on profit of 20 add 0.24, together more than half the gap to neutral.

Can a high M-score be a false alarm?

Yes. Acquisitions lift sales growth, receivables and soft assets for reasons unrelated to accounting choices, and fast organic growth raises SGI on its own. For the illustrative borrower, collecting the 9.6 of excess receivables in cash would lower the score from -1.63 to -2.07, which is why the next step is to test the receivables ageing, not to conclude.

Also on this site

• What is an EBITDA add-back bridge actually worth in leverage turns?Six add-backs move leverage 1.6866 turns; the 4.25x covenant leaves 0.0336 of a turn. The bridge is 50.3 times the headroom it is tested against.
• How do you calculate the Altman Z-score, and which version applies?Five ratios times fixed weights. One private borrower scores 2.18 on the original Z, 1.67 on Z' and 2.44 on Z'': grey on all three, but only Z' is the right test.
• Is a quality of earnings report worth it for a small business?Yes if the SDE it removes, times the multiple, beats the fee. At 3.0x a 30,000 QoE breaks even at 10,000 of SDE; here it finds 83,000 and cuts the price 249,000.
• What probability of default does a loan margin break even at?Margin over loss given default: 400 bp against an LGD of 26.52 per cent breaks even at a 15.08 per cent PD, and at 8.91 per cent if the exit multiple is 3.0x.
• How do you estimate a credit rating from financial ratios?Score each ratio on a rating grid, weight the scores and map back to a letter. At 3.30x leverage and 5.38x cover, a $850m distributor scores 4.15: BBB.
• How many years does it take to repay debt from free cash flow?Solve for the year the debt hits zero as interest falls: 120,000,000 at 4.22x leverage takes 9.12 years from 9,680,000 of free cash flow, not four.

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