The Kingdom of Ledgeria and the Oracle of Financial Doom: Altman Z Score, M Score

In the grand kingdom of Ledgeria, the economy thrived with merchants, guilds, and investors pouring gold into the realm. But a dark shadow loomed—some businesses were not as healthy as they appeared. The Royal Treasury feared that some were on the brink of collapse, while others were hiding fraud in their records.

To prevent a financial catastrophe, King Aldric the Wise summoned two legendary oracles—one to predict which companies would fail and another to uncover financial trickery.

The Oracle of Altman’s Z-Score: The Fortune Teller of Bankruptcy

The first oracle, Altman the Mathemagician, devised a mystical formula to determine whether a company was heading toward bankruptcy.

He declared:

"If a company’s Z-Score is below 1.8, beware! It may fall into the abyss of financial ruin. But if it is above 3.0, the kingdom can rest easy."

His formula combined five powerful ratios, each revealing a company’s financial strength:

$$Z = 1.2(X_1) + 1.4(X_2) + 3.3(X_3) + 0.6(X_4) + 1.0(X_5)$$

Where:

• X₁ (Working Capital / Total Assets) → Measures liquidity (how easily a company can meet short-term obligations).
• X₂ (Retained Earnings / Total Assets) → Shows profitability over time (how much profit has been reinvested).
• X₃ (EBIT / Total Assets) → Checks operating efficiency (earnings before interest and taxes).
• X₄ (Market Value of Equity / Total Liabilities) → Tests market confidence in the company.
• X₅ (Sales / Total Assets) → Examines asset efficiency (how well assets generate revenue).

The King tested this formula on several companies, and true to Altman’s words, those with Z-Scores below 1.8 crumbled, while those above 3.0 remained strong.

But not all troubled companies went bankrupt—some were merely deceptive.

The Oracle of Beneish M-Score: The Fraud Detector

That’s when Oracle Beneish, a sharp-eyed forensic accountant, revealed his own formula—the M-Score—to detect financial fraud and earnings manipulation.

His magic formula was:

$$M = -4.84 + 0.92(DSRI) + 0.528(GMI) + 0.404(AQI) + 0.892(SGI) + 0.115(DEPI) - 0.172(SGAI) + 4.679(TATA) - 0.327(LEVI)$$

Where:

• DSRI (Days Sales in Receivables Index) → Checks if accounts receivable are growing suspiciously fast.
• GMI (Gross Margin Index) → A declining gross margin may signal earnings manipulation.
• AQI (Asset Quality Index) → A rise in non-productive assets could mean hidden expenses.
• SGI (Sales Growth Index) → Too much growth can pressure managers into fraud.
• DEPI (Depreciation Index) → A lower depreciation rate than before may indicate earnings inflation.
• SGAI (Sales, General & Admin Expenses Index) → A sharp rise in administrative costs may signal manipulation.
• TATA (Total Accruals to Total Assets) → Higher accruals indicate aggressive accounting.
• LEVI (Leverage Index) → Increased leverage means higher financial risk.

If a company had an M-Score above -2.22, there was a high probability it was manipulating earnings.

The Kingdom’s Financial Renaissance

Using these two powerful formulas, King Aldric and his advisors saved the kingdom from financial disaster. Investors used Altman’s Z-Score to avoid bankrupt companies and Beneish’s M-Score to detect fraud before investing.

And thus, Ledgeria prospered, with honest businesses flourishing and fraudulent ones exposed before they could wreak havoc.

[Finance]