How we grade earnings quality
Methodology
EarningsGrade screens US stocks using forensic accounting techniques. Every grade is backed by 18 quantitative checks, three academic scoring models, and 5 years of financial data from SEC filings.
Grading System
Each stock receives an A through F grade based on how many checks it fails and how severe the failures are.
18-Point Screening
Six categories, each targeting a different type of financial shenanigan (per Schilit's framework).
A. Revenue Quality
Days Sales Outstanding change year-over-year. Rising DSO suggests loosening credit terms or channel stuffing.
Accounts Receivable growth vs Revenue growth. AR growing faster than revenue for 2+ years is a classic manipulation signal.
Revenue growth vs Cash Flow from Operations growth. Revenue growing faster than cash flow suggests non-cash revenue recognition tricks.
B. Expense Quality
Inventory growth vs Cost of Goods Sold growth. Inventory piling up faster than sales suggests obsolescence or demand problems.
Capital Expenditure growth rate vs Revenue growth rate. CapEx growing much faster may signal over-investment or empire building.
SG&A as percentage of Gross Profit. Rising ratios suggest deteriorating operating leverage.
Gross Margin trend over 3+ years. Sustained decline indicates pricing pressure or cost inflation not passed through.
C. Cash Flow Quality
Cash Flow from Operations / Net Income ratio. Below 1.0 for multiple years means reported profits aren't turning into cash.
FCF = CFFO - CapEx. Negative FCF for 3+ years while reporting profits is a serious red flag.
(Net Income - CFFO) / Total Assets. High positive accruals mean profits are paper-based, not cash-based.
Cash & equivalents / Total Debt. Below 30% means limited liquidity buffer.
D. Balance Sheet Quality
Goodwill + Intangibles as % of Shareholder Equity. Above 40% means the balance sheet is built on acquisition promises, not hard assets.
Debt/EBITDA ratio. Above 4x is stress territory. Above 6x is distress.
Other assets growth significantly exceeding revenue growth. May indicate off-balance-sheet games.
Significant goodwill or asset impairments in recent years.
E. Acquisition Quality
Free Cash Flow after acquisitions. Negative for 3+ years means the company is a serial acquirer funding deals with debt, not earnings.
Year-over-year goodwill growth. A sudden surge indicates a major acquisition that may be overpriced.
F. Manipulation Detection
8-variable model. Below -2.22 = safe. Between -2.22 and -1.78 = grey zone. Above -1.78 = likely manipulator. 76% historical accuracy.
Scoring Models
Beneish M-Score
Developed by Professor Messod Beneish (1999). An 8-variable model that detects earnings manipulation by measuring distortions in financial statements.
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- DSRI — Days Sales in Receivables Index
- GMI — Gross Margin Index
- AQI — Asset Quality Index
- SGI — Sales Growth Index
- DEPI — Depreciation Index
- SGAI — SG&A Index
- TATA — Total Accruals to Total Assets
- LVGI — Leverage Index
Below -2.22: Safe | -2.22 to -1.78: Grey zone | Above -1.78: Likely manipulator
Altman Z''-Score
Non-manufacturing variant of the Altman Z-Score. Predicts financial distress within 2 years. Not applicable to financial companies (banks, insurance, REITs).
Z'' = 6.56×X1 + 3.26×X2 + 6.72×X3 + 1.05×X4- X1 — Working Capital / Total Assets
- X2 — Retained Earnings / Total Assets
- X3 — EBIT / Total Assets
- X4 — Book Value of Equity / Total Liabilities
Above 2.60: Safe | 1.10 to 2.60: Grey zone | Below 1.10: Distress
Dechow F-Score
Developed by Patricia Dechow (2011). A 7-variable predicted probability of financial misstatement. Used as a parallel indicator — does not affect the A-F grade.
PV = -7.893 + 0.790×rsst_acc + 2.518×ch_rec + 1.191×ch_inv + 1.979×soft_assets + 0.171×ch_cs - 0.932×ch_roa + 1.029×issue- rsst_acc — Richardson accruals (WC + NCO + FIN changes)
- ch_rec — Change in receivables / avg assets
- ch_inv — Change in inventory / avg assets
- soft_assets — (Total Assets - PP&E - Cash) / Total Assets
- ch_cs — Change in cash sales
- ch_roa — Change in return on assets
- issue — Whether securities were issued
Predicted probability > 50%: High misstatement risk
Data Sources
Important Disclaimers
- *This is NOT investment advice. A failing grade does not mean sell. A passing grade does not mean buy.
- *The screening framework has known limitations. Some business models (utilities, REITs, financial companies, asset-light SaaS) may trigger structural flags that are features, not bugs.
- *Grades are based on the most recent annual filing. Financial conditions can change rapidly between filings.
- *The M-Score has a 76% historical accuracy rate. It can produce both false positives and false negatives.
- *Past financial health does not predict future performance.