Percentile scoring against a relevant peer groupAt the core of our accounting screen is a process which analyses over 60 accounting and corporate governance data points (these can easily be expanded upon at the request of users) which tackle almost every line item within a set of financial statements. Each item is compared to a company’s sales, resulting in a ratio which is then compared against a relevant peer group deriving a percentile score, with zero being a good score and 100 being bad. Normally, this comparison would be against relevant industry peers (Global Industry Classification Standard ) but in some cases is against country of domicile or global peers (users have the option to override our default settings). We deem companies to raise red flags when their ratios exceed the 80th worst percentile relative to their peer group, although for some ratios red flags are raised in the lowest 20 percentiles. Each time a red flag is raised, the spreadsheet highlights it in red.We believe that a comparison of financial items against sales is far more insightful than against assets or equity. The equity of a company is simply a function of leverage. A number of flags would, therefore, be triggered by companies which are undercapitalised. Also, the level of a company’s assets can simply be a function of capital structure.
In addition to the absolute ratio, we calculate the change in each ratio over one and three years. While the absolute level of ratio is interesting, incremental changes are, arguably, of greater interest in understanding cash flow and profit generation. We then compare this change against the changes seen by a similar peer group over one and three years between 2010 and 2015, and percentile rank the result. In order to express the number in a more intuitive way, we take the percentile score and subtract by 50. As a result, deteriorating ratios generally score from +1 to +50 (+1 being a slight deterioration whilst +50 would represent a significant deterioration), while improving ratios score from -1 to -50.
The idea behind percentile scoring is to give analysts a sense of perspective as to whether a company’s ratio is broadly in line with companies with a similar business model. In order to find a similar set, we have downloaded data from over 16,000 companies globally between 2010 and 2015. From these we have created bell-curves for 63 ratios, across 65 industries and a further 60 countries. Within the spreadsheet each ratio is hyperlinked to an explanation hosted on our website.
The reason it is so important to compare ratios to an appropriate peer group is because business models vary enormously by industry. For example, the median average receivable for the Electrical Equipment industry was 25% of sales between 2010 and 2015. This is in excess of the 80th worst percentile for almost half of all industries. As such, if we simply compared the typical receivable of an Electronics Equipment company to our entire sample it would trigger a red flag. The same is true for changes in receivable days. Those business models with the largest receivables are likely to report the largest changes in receivable days and should, therefore, be compared to a similar peer group.
In order to calculate a simple score that encapsulates the financial integrity of a company’s financial statements, we have come up with two methodologies: an average ratio percentile score and a red flag score.
Average Ratio Percentile Score: Ratio in Latest Financial Period
Any attempt to come up with a one number score for a company’s financial statements is an oversimplification of a very complicated situation. It is the combination of a few key red flags which is often a warning sign of profit manipulation or outright fraud. Still, our readers are busy and want to see such a number. As such, for the Average Ratio Percentile Score we first calculate a simple average of our 63 ratios. Secondly, we compare the average score against companies in the same GICS industry to derive our final percentile score. For example, a company might have an average ratio percentile score of 42% which would be in the 17% best percentile relative to industry peers globally. This would be regarded as a pretty good score.
We have used the data from the 16,000 companies in our sample to calculate how a typical company in each country scores relative to its global industry peers for 2015. As Figure 1 shows, Saudi Arabian companies have the worst over score. This does not necessarily mean that they have the highest incidence of fraud; it might simply suggest that they run lazy balance sheets. In Asia, Chinese companies score the worst, followed by Hong Kong and then Singaporean companies. Meanwhile, companies in Vietnam, Pakistan and Thailand score the best.