You will be able to score earnings quality and use known screening models to flag accounts that need a closer read.
Most accounting problems that blow up a share price were visible in the published accounts for a year or more before the blow-up. Profit kept rising while cash didn't, receivables grew faster than sales, and assets appeared on the balance sheet that nobody could quite explain. Analysts who caught them early weren't smarter than everyone else. They ran a few simple tests every year on every company they followed, and paid attention when a test failed.
This lesson gives you those tests, applied to Larkspur's made-up FY5 figures in S$ millions.
The first test compares operating cash flow with profit. Cash conversion is operating cash flow divided by net profit.
Larkspur's operating cash flow was 66 and its net profit 48, so cash conversion was about 138%. For a company with heavy depreciation, conversion above 100% is normal, because depreciation reduces profit but not cash. Some analysts use free cash flow instead, which gives a tougher figure: 32 over 48, about 67%.
One year tells you little. Run it for five years and look at the pattern. A business whose conversion sits persistently well below its usual level, or below 100% when depreciation should lift it above, is booking profit that isn't arriving as cash. The usual culprits are receivables and inventory growing faster than sales, or income recognised before it's received.
Accruals are the accounting entries that make profit differ from cash: revenue booked but not collected, costs deferred, assets revalued. Some accrual is unavoidable and honest, but a lot of it is a warning sign, because accruals are where management's estimates live.
The accruals ratio measures how much of profit comes from accruals rather than cash. One simple version is net profit minus operating cash flow, divided by average total assets. For Larkspur: 48 minus 66 is minus 18. Average total assets over the year were 389 and 410, so about 399.5. The ratio is about minus 4.5%.
A negative ratio means cash exceeded profit, which is reassuring. A high positive ratio, where profit runs well ahead of cash relative to the company's size, has been linked in academic research to weaker future earnings and returns, though the effect varies by market and period. Treat a rising positive ratio as a reason to read the notes on revenue and working capital again.
Messod Beneish, an accounting professor, published a model in 1999, now known as the Beneish M-score, that screens for signs that a company has manipulated its earnings. It combines eight ratios, each comparing this year with last year, into a single score.
Days sales in receivables index, gross margin index, asset quality index, sales growth index, depreciation index, selling and administrative expenses index, an index of debt to assets, and total accruals to total assets
Each captures a pattern Beneish found in companies later caught manipulating: receivables growing faster than sales, margins slipping, costs being capitalised as assets, fast growth that creates pressure to keep it up, depreciation slowing, and profit running ahead of cash. Higher scores look more like the manipulators in his sample.
You don't have to compute all eight to use the idea. Take the first. Larkspur's receivables were 20% of revenue in FY5, 80 over 400, against about 20.8% in FY4, 75 over 360. The index is 0.96, below 1, so receivables grew more slowly than sales. That's the opposite of a warning. Many data providers and screening tools calculate the full score if you want it.
Edward Altman, a finance professor, published the Altman Z-score in 1968 to estimate the risk that a company will fall into financial distress. The original version, built from US listed manufacturing companies, weights five ratios.
The weights are 1.2 on working capital to total assets, 1.4 on retained earnings to total assets, 3.3 on operating profit to total assets, 0.6 on market value of equity to total liabilities, and 1.0 on sales to total assets. In Altman's original work, scores above about 2.99 fell in a safe zone and scores below about 1.81 in a distress zone, with a grey area between.
Note that Altman's working capital here is current assets minus current liabilities, a wider measure than the one lesson 7.3 used for modelling. For Larkspur, current assets were 210: cash of 60, receivables of 80 and inventory of 70. Current liabilities were 59: payables of 45, plus the parts of debt and leases due within a year. Working capital in this sense was 151.
With total assets of 410, retained earnings of 185, operating profit of 56, a market value of 480 at S$1.60 a share and total liabilities of 125, the five terms come to about 0.44, 0.63, 0.45, 2.30 and 0.98. The Z-score is about 4.8, comfortably in the safe zone. Larkspur's low debt and its market value well above its liabilities do most of the work.
Both models were built on particular samples of US companies decades ago. Neither suits banks or insurers, whose balance sheets work differently. Both throw up false alarms, flagging fast-growing honest companies, and both miss frauds that are well hidden. A score tells you where to look harder, never what the answer is.
Used that way they're very useful. A company with falling cash conversion, a rising accruals ratio and a receivables index above 1 for two years running has given you three separate reasons to reread its revenue note and its auditor's report before you add a dollar.
For the activity, calculate cash conversion, the accruals ratio and the Altman Z-score for your company for each of the last three years.
Calculate cash conversion, the accruals ratio and the Altman Z-score for your company for the last three years.
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