For the data analysis, Altman Z score is applied to check the financial status of the selected

companies and Beneish M score is applied to check whether the financial statements of the
selected companies are manipulated or not.

Altman’s Z-Score Model

A numerical measurement used to predict the chances of a business going bankrupt in the next
two years

What is the Z-score of bankruptcy?

A Z-score that is lower than 1.8 means that the company is in financial distress and with a high
probability of going bankrupt. On the other hand, a score of 3 and above means that the company
is in a safe zone and is unlikely to file for bankruptcy.

What is Altman’s Z-Score Model?

Altman’s Z-Score model is a numerical measurement that is used to predict the chances of a
business going bankrupt in the next two years. The model was developed by American finance
professor Edward Altman in 1968 as a measure of the financial stability of companies.

The Beneish M-score is a mathematical model utilizing financial ratios and eight variables to know if
the company has manipulated its earnings. The variables are constructed from the company's financial
statements data to create an M-Score that describes how much the earnings have been manipulated.
Altman’s Z-score model is considered an effective method of predicting the state of financial
distress of any organization by using multiple balance sheet values and corporate income.
Altman’s idea of developing a formula for predicting bankruptcy started at the time of the Great
Depression, when businesses experienced a sharp rise in incidences of default.

Summary

• Altman’s Z-score Model is a numerical measurement that is used to predict the

chances of bankruptcy.
• American Edward Altman published the Z-score Model in 1968 as a measure of the
probability of a company going bankrupt.
• Altman’s Z-score model combines five financial ratios to predict the probability of a
company becoming insolvent in the next two years.

Altman’s Z-Score Model Explained

The Z-score model was introduced as a way of predicting the probability that a company would
collapse in the next two years. The model proved to be an accurate method for predicting
bankruptcy on several occasions. According to studies, the model showed an accuracy of 72% in
predicting bankruptcy two years before it occurred, and it returned a false positive of 6%. The
false-positive level was lower compared to the 15% to 20% false-positive returned when the model
was used to predict bankruptcy one year before it occurred.

When creating the Z-score model, Altman used a weighting system alongside other ratios that
predicted the chances of a company going bankrupt. In total, Altman created three different Z-
scores for different types of businesses. The original model was released in 1968, and it was
specifically designed for public manufacturing companies with assets in excess of $1 million. The
original model excluded private companies and non-manufacturing companies with assets less
than $1 million.
Later in 1983, Altman developed two other models for use with smaller private manufacturing
companies. Model A Z-score was developed specifically for private manufacturing companies,
while Model B was created for non-publicly traded companies. The 1983 Z-score models
comprised varied weighting, predictability scoring systems, and variables.

Altman’s Z-Score Model Formula

The Z-score model is based on five key financial ratios, and it relies on the information
contained in the 10-K report. It increases the model’s accuracy when measuring the financial
health of a company and its probability of going bankrupt.

The Altman’s Z-score formula is written as follows:

ζ = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

1.2* WC/ TA+1.4B*RE/TA+3.3*EBIT/TA+0.6 MV of Equity/ TL+1.0 TSales/ T Asset

Where:

• Zeta (ζ) is the Altman’s Z-score

• A is the Working Capital/Total Assets ratio
• B is the Retained Earnings/Total Assets ratio
• C is the Earnings Before Interest and Tax/Total Assets ratio
• D is the Market Value of Equity/Total Liabilities ratio
• E is the Total Sales/Total Assets ratio

What Z-Scores Mean

Usually, the lower the Z-score, the higher the odds that a company is heading for bankruptcy. A
Z-score that is lower than 1.8 means that the company is in financial distress and with a high
probability of going bankrupt. On the other hand, a score of 3 and above means that the company
is in a safe zone and is unlikely to file for bankruptcy. A score of between 1.8 and 3 means that
the company is in a grey area and with a moderate chance of filing for bankruptcy.

Investors use Altman’s Z-score to make a decision on whether to buy or sell a company’s stock,
depending on the assessed financial strength. If a company shows a Z-score closer to 3, investors
may consider purchasing the company’s stock since there is minimal risk of the business going
bankrupt in the next two years.

However, if a company shows a Z-score closer to 1.8, the investors may consider selling the
company’s stock to avoid losing their investments since the score implies a high probability of
going bankrupt.

The Five Financial Ratios in Z-Score Explained

The following are the key financial ratios that make up the Z-score model:
1. Working Capital/Total Assets

Working capital is the difference between the current assets of a company and its current
liabilities. The value of a company’s working capital determines its short-term financial health.
A positive working capital means that a company can meet its short-term financial obligations
and still make funds available to invest and grow.

In contrast, negative working capital means that a company will struggle to meet its short-term
financial obligations because there are inadequate current assets.

2. Retained Earnings/Total Assets

The retained earnings/total assets ratio shows the amount of retained earnings or losses in a
company. If a company reports a low retained earnings to total assets ratio, it means that it is
financing its expenditure using borrowed funds rather than funds from its retained earnings. It
increases the probability of a company going bankrupt.

On the other hand, a high retained earnings to total assets ratio shows that a company uses its
retained earnings to fund capital expenditure. It shows that the company achieved profitability
over the years, and it does not need to rely on borrowings.

3. Earnings Before Interest and Tax/Total Assets

EBIT, a measure of a company’s profitability, refers to the ability of a company to generate

profits solely from its operations. The EBIT/Total Assets ratio demonstrates a company’s ability
to generate enough revenues to stay profitable and fund ongoing operations and make debt
payments.

4. Market Value of Equity/Total Liabilities

The market value, also known as market capitalization, is the value of a company’s equity. It is
obtained by multiplying the number of outstanding shares by the current price of stocks.

The market value of the equity/total liabilities ratio shows the degree to which a company’s
market value would decline when it declares bankruptcy before the value of liabilities exceeds
the value of assets on the balance sheet. A high market value of equity to total liabilities ratio can
be interpreted to mean high investor confidence in the company’s financial strength.

5. Sales/Total Assets

The sales to total assets ratio shows how efficiently the management uses assets to generate
revenues vis-à-vis the competition. A high sales to total assets ratio is translated to mean that the
management requires a small investment to generate sales, which increases the overall
profitability of the company.
In contrast, a low or falling sales to total assets ratio means that the management will need to use
more resources to generate enough sales, which will reduce the company’s profitability.
Beneish Model: Definition, Examples, M-
Score Calculation
By
Will Kenton
Updated October 25, 2021
Reviewed by Margaret James
Fact checked by Kirsten Rohrs Schmitt

Investopedia / Ellen Lindner

What Is the Beneish Model?

The Beneish model is a mathematical model that uses financial ratios and eight variables to identify
whether a company has manipulated its earnings. It is used as a tool to uncover financial fraud.

The variables are constructed from the data in the company's financial statements, and once
calculated, create an M-Score to describe the degree to which the earnings have been manipulated.

Key Takeaways

• The Beneish model is a mathematical model that uses financial ratios and eight variables
to identify whether a company has manipulated its earnings.
• The variables are constructed from the data in the company's financial statements to
create an M-Score that serves to describe how much the earnings have been manipulated.
• A primary application of the Beneish model is as a tool to uncover financial fraud.
• Professor M. Daniel Beneish of the Kelley School of Business at Indiana University
created the model, which he published in a paper in 1999.
• Famously, a group of Cornell University business students used the Beneish model to
predict that Enron Corporation was manipulating their earnings.

Who Created the Model?

Professor M. Daniel Beneish of the Kelley School of Business at Indiana University created the
model. While he had been working on the model for years, Beneish's paper, "The Detection of
Earnings Manipulation" was published in 1999.1

Professor Beneish has written a number of follow-up studies and extensions since first
publishing the model. Beneish's webpage at the business school has an M-Score calculator.2

Understanding the Beneish Model

The basic theory that Beneish bases the ratio upon is that companies may be more likely to
manipulate their profits if they show deteriorating gross margins, operating expenses, and
leverage both rising, along with significant sales growth. These factors may cause profit
manipulation through various means.

The Beneish model's eight variables are:

1. DSRI: Days' sales in a receivable index

2. GMI: Gross margin index
3. AQI: Asset quality index
4. SGI: Sales growth index
5. DEPI: Depreciation index
6. SGAI: Sales and general and administrative expenses index
7. LVGI: Leverage index
8. TATA: Total accruals to total assets

The formula for calculating the Benish M-score is:

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.

Once these eight variables are calculated, they are then combined to achieve an M-Score for the
company. An M-Score of less than -1.78 suggests that the company will not be a manipulator.
An M-Score of greater than -1.78 signals that the company is likely to be a manipulator.3

Real World Examples of the Beneish Model's Application

In 1998, a group of Cornell University business students used the Beneish model to predict that
Enron Corporation was manipulating their earnings.

At the time, Enron stock was trading at only about half ($48 per share) of the price to which it
eventually climbed ($90) before its dramatic fall into ruin and bankruptcy a few years later in 2001.
At the time the Cornell students sounded the alarm, no one on Wall Street heeded their advice.

Many professional investment firms and investors use the model as part of the assessment process
for the companies they track, and factor in a company's Beneish M-Score when deciding which
companies in which they will invest.