To be successful in any trade, delivering committed services must always be the ultimate goal of companies. Protecting shareholders’ investment is the key to success. In most cases, financial staff members struggle in deciphering financial information, since it is a tedious process that requires meticulous valuation and analysis. This observation compels business owners and their financial management team to utilize quantitative tools in decision making, such as ratio analysis.
Ratio Analysis Defined
Each year, companies conduct annual reporting in order to determine which processes are effective and which are not. In order to achieve an intelligent decision making process in terms of investment, ratio analysis is employed. It is a method of systematically manipulating numbers based on financial statements; this is a proven financial analysis strategy tool that converts quantities into ratios.
Advantages and Limitations
By utilizing ratio analysis, a company can meticulously analyze its financial performance. Ratio analysis points out the strengths and weaknesses of the company, which is crucial when setting better financial goals. Other applications of utilizing ratio analysis include financial statement analysis, determining efficiency of both management and operations in terms of generating profits, finding weak points of previous action plans, and, most importantly, formulating new sets of goals.
On the other hand, there are certain limitations when employing ratio analysis. For large companies, it has been a challenge to identify significant sets of ratios that conform to the industry standards. This is due to various divisions in different industries. Inflation presents another limitation, since it impacts profit. Seasonal factors and different accounting practices are also known limitations of ratio analysis.
Preventing Fraud Using Ratios
One of the goals of utilizing ratio analysis is determining the weakness of a financial firm and its processes. Part of this is ensuring that financial information integrity is preserved. Hence, detection of fraud should be given equal importance. In a corporate setup, financial ratios can be protected by keeping track of total assets and liabilities, profit trends, company tenure and size, comparison of sales to total assets, and the basis of revenue. These are the logical variables that should help ensure fraud is prevented.
Key Ratio and Analysis (Benford Law)
Looking at the digital data an examining the patterns of the data is a relatively new approach being used to prevent fraud. In order to achieve an efficient financial information analysis, auditors have learned to use advanced data analysis application. This is the same tool that fraud investigators have begun using, as well. Indeed, digital analysis has made it easier to detect and identify the existence of fraud even before it happens. Today, trend analysis and forecasting work hand in hand in delivering profit to every corporation that utilizes ratio analysis. By constantly monitoring financial trends, financial professionals can easily create forecast data, which will be used in setting new sets of goals at year’s end. Done manually, this process can be quite tedious.
Some simple transactions that have been able to be more easily identified with this method is the duplication of invoices. Another useful fraud detection technique is the calculation of ratios for key numeric fields and also the analysis of trends to identify fraud. However, there is also a more advanced method such as Benford Law, which is the analysis of the actual frequency of the digits in the data. This is a much more complex method which you can learn about more here.
However, There are many types of formulas that are accessible used to prevent such crimes. There are two types, Type A, which are actual statistical ways of proving financial fraud but also Type B which is more there to identify potential warning signs.
- Look at invoices with duplicate transactions (Same amount, Same date, same vendor or 2 or more novices matching on 5 out 6 digits separated by a dot, space, etc with the vendor name and date)
- Round dollar invoices / payments. Very rare!
- Product variance. Look at individual product line and the variance.
- Receipt generated amount and submitted amount (Cash counter fraud , small time fraud)
- Fraud Z-Score Model – Beneish developed this in 1999 and is a statistical model used to detect financial statement fraud and earnings management through a variety of metrics including sales growth index, gross margin index, asset quality index, Days sales in receivables index and total accruals to total assets. A smaller negative number or a positive number indicates possible financial reporting problems (Beneish 1999). For example, Enron had a Z-Score of a positive 0.045 in its last year.
- Fraud F-Score Model – Was founded in 2007 and can be used as another initial test in determining the likelihood of financial reporting manipulation. A fraudulent score for this model does not necessarily imply such manipulation but it serves as a red flag for further analysis.
- Sloan Accrual Measure – This is based on the analysis of accrual components of earnings calculated by net income less free cash flows (operating cash flow minus capital expenditures) divided by average total assets.
- Quality of Earnings – A simple way to judge the quality of a company’s reported net income.
- Quality of Revenues – Emphasis on cash relative to sales as opposed to net income like in quality of earnings.
- Altman Z-Score – The Statistical formula used to forecast the probability a company will enter bankruptcy within the next 2 years.
The analysis of the data using these formulas will be able to help someone predict the likelihood of possible financial fraud. There are tools available who would just do it for you.
Compared to type A, these tests do not necessarily indicate fraud through statistics but can be used as merely warnings signs to investors.
1. Accounts receivable (AR) growth versus sales growth
If AR growing faster than sales than it indicates that either the revenue collection cycle is too long or customers are not paying. Either situation reduces liquidity. So What out for this figure when comparing the same on year on year basis. Additionally, company ship products to customers even through they might have not ordered the same and record it as sales. This is called ‘channel stuffing’. Channel stuffing creates a spike in AR.
2. Property, plant, and equipment (PPE) as a percentage of total assets
PPE are companies’ long term assets. All companies have PPE on their balance sheet. For a Motor vehicle producing company a PPE would be a factor, while for a financial institution it might be an office building. This figure is a ‘slow & steady’ moving giant, a flash in either direction will be worth scrutinizing.
So what would it incite?
For a product producing company, it may mean it is capitalizing routine expenses. Ahem! WorldCom!!!. A negative / declining case may indicate the money is not flowing in to their core business. If not where? Shell companies?
3. Operating cash flow versus earnings per share (EPS)
This activity is associated with investments how, when proper or improper. If EPS consistently exceeds operating cash flow, it indicates poor earnings quality. Companies with poor earnings quality make poor investments.
4. Cost of goods sold (COGS) as a percentage of sales.
COGS is nothing but what the company pays for inventory which then it sells it to its customer. It is normal for a company to legitimately play around, with change in strategies and what is expected from the market. However, a large variance in this could be represented because of some accounting irregularities (As I have learned from my investigations, it is also because people apply a wrong accounting standard (Seriously! A 15 years experienced accountant saying that)
5. Accounts payable versus sales growth
This is a simple one. So if company doesn’t pay what it owes, there has to be a legitimate (or illegitimate) relation with the vendor. What is such a generous vendor? Need some checking! In the long run if payables are growing faster than sales, means that there is some cash outflow sitting to be paid ( never used?, Is it present? Who has the authority to use that (Look at delegation of authority)
There have been a number of famous examples where companies have been caught red-handed trying to fraud the stock market through their accounts. In 2001, the gigantic energy company Enron filed a $618 million third quarter loss. In order to cover up their huge losses, Enron used their auditing firm, Arthur Andersen, to doctor their financial statements by taking advantage of lax US GAAP rules. You can read more into it here. However, long story short, the SEC and forensic accountants found out, realised what they were trying to do and eventually led to the company’s demise as if filled for bankruptcy in December 2001.
Arguably one of the best cases however was the ZZZZ BEST case, a company set up by entrepreneur Barry Minkow. After growing his carpet cleaning and renovation Service Company into having an established position on Wall Street, it was later revealed as a multimillion-dollar fraud. Beginning with credit card forgeries, insurance fraud, check kiting, and later reporting fictitious revenues from ‘insurance restoration’ contracts Barry’s business was a complete scam, funded by illegal activity complete with embellished financial reports that stock brokers believed and auditors failed to identify. Eventually the scam was identified and Barry found guilty on 57 counts of security fraud and a lessoned learned to the entire auditing community for the necessity to have a “professional scepticism” about every company.
Ratio analysis is an effective tool for delivering values to business owners and their customers. When used effectively, ratio analysis can help a business achieve its profit goals by ensuring that data integrity is monitored and corrected, especially if fraud is detected.