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Should investors worry about accounting red flags at Eve Sleep PLC (LON:EVE)?

11th Mar '19 by Ben Hobson

As an investor, I want to know that I can rely on the accounts of the companies I buy shares in - and I bet you do too.

Accounting errors can be entirely innocent... but sometimes they're deliberately misleading. Either way, the market response is usually swift and severe. Uncertainty about a company's earnings or the way it reports its figures will inevitably cause its share price to plummet.

What most investors don’t realise is that there are algorithmic ways to check the credibility of company earnings - and one of them is called the Beneish M-Score. In this article I’m going to explain how it works by looking at Eve Sleep (LON:EVE) as an example.

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About Eve Sleep (LON:EVE)

Eve Sleep is a highly speculative, micro cap in the Internet Services industry - specialising in mattresses and other sleep products.

In terms of price performance, the Eve Sleep share price has seen 1-year relative strength against the the FTSE All-Share index of -93.4% - so it has significantly underperformed the market.

For the six months ended 30 June 2018, Eve Sleep revenues increased 63% to £18.8M. Its net loss increased 32% to £12M.

In addition, the Beneish M-Score - which I’ll explain shortly - shows that there are areas in Eve Sleep's accounts that might be worth closer investigation.

It's important to note that this doesn’t mean that Eve Sleep is doing anything wrong. But it does mean that the risks could be higher than for other shares. As an investor, you should know what these red flags mean - both in Eve Sleep and any other stock you might be thinking of buying.

How the Beneish M-Score works

In 1999, a finance professor called Messod Daniel Beneish published a landmark research paper entitled The Detection of Earnings Manipulation. It showed how you can use accounting data to spot problems early.

Since then it’s become an indispensable checklist for professional money managers and investment banks - and you can use it too.

Professor Beneish’s M-Score looks at the year-on-year change in eight different ratios that can be worked out from a company’s financial statements. It looks for these red flags:

  • Inflated revenues
  • Declining gross margins
  • Capitalised and deferred costs
  • Excessive sales growth
  • Lengthening depreciation periods
  • Rising sales expenses
  • Increasing leverage
  • Higher accruals

Ideally, you and I would want our stocks to be passing these checks with ease. But when a company fails one or more of them, it’s time to dig deeper into the accounts to find out why.

Are there accounting risks at Eve Sleep?

Here is a graphic that shows how Eve Sleep stacks up against the M-Score checklist.

5c869e2dace63beneish_eve.png

As you can see, there are two areas of concern based on Professor Beneish's checklist.

Next steps

Armed with this information, you might want to explore the accounts on Eve Sleep's StockReport to understand what the red flags mean and whether they point to possible risks.

In addition, you can use this Beneish M-Score Cheat Sheet to check for earnings manipulation risks in any stock in the market. You can also check to see which other stocks fail the Beneish M-Score test with this constantly updated screen.

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