The Use of Financial Ratios to Detect Fraud and Financial Manipulation

At the SEC, financial ratio analysis is used in horizontal and vertical capacities to detect potential fraud or financial manipulation. The following are used alongside a variety of other metrics and processes to identify risks:

Earnings Quality Score

“What percentage of our net income contributes to cash flow from operations?”

Earnings Quality measures the percentage of Net Income that contributes to Cash Flow from operations. As Earnings Quality decreases, the potential risk of manipulation increases.

Z-Score

“How likely are we to go bankrupt?”

The Z-Score can be used as a predictor of bankruptcy in manufacturing companies, and is calculated as follows:

Z-SCORE = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets

M-Score

“Have we manipulated earnings?”

M-Score is a mathematical model that uses eight financial ratios to identify whether a company has manipulated its earnings.  The M-Score has been used to identify 76% of manipulations correctly.

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

DSRI = (Net Receivablest / Salest) / Net Receivablest-1 / Salest-1)

GMI = [(Salest-1 – COGSt-1) / Salest-1] / [(Salest – COGSt) / Salest]

AQI = [1 – (Current Assetst + PP&Et + Securitiest) / Total Assetst] / [1 – ((Current Assetst-1 + PP&Et-1 + Securitiest-1) / Total Assetst-1)]

SGI = Salest / Salest-1

DEPI = (Depreciationt-1/ (PP&Et-1 + Depreciationt-1)) / (Depreciationt / (PP&Et + Depreciationt))

SGAI = (SG&A Expenset / Salest) / (SG&A Expenset-1 / Salest-1)

LVGI = [(Current Liabilitiest + Total Long Term Debtt) / Total Assetst] / [(Current Liabilitiest-1 + Total Long Term Debtt-1) / Total Assetst-1]

TATA = (Income from Continuing Operationst – Cash Flows from Operationst) / Total Assetst

Meet-or-Beat Earnings

“What percent of periods do we meet or beat earnings predictions by 1-2¢?”

Meet-or-beet calculates the percentage of periods that meet or beat analyst’s predictions.  When companies consistently meet or beat earnings within \$0.01-0.02, the likelihood that the company manipulated earnings increases.