Numbers never lie, but people sometimes do. Throughout history, accounting frauds have been used to make a business appear healthy and profitable. From Sunbeam to Enron to WorldCom, these frauds went undetected, grew, and eventually destroyed the company.
Although auditors often miss frauds and corporate mangers do their best to conceal them, investors have the potential to detect possible problems. Using publicly available financial statements, we can compare different metrics to determine whether the accounting looks weak and trouble lurks. While these tests do not indicate fraud per se, they are warnings that investors should remain cautious. The five main ratios that may foretell financial danger are:
1. Accounts receivable growth versus sales growth – When a company sells goods or services, it often delivers the product with a promise from the customer that he or she will pay for the item at a future date. This promise creates an account receivable. If we see accounts receivables growing faster than sales it could indicate that the company is extending credit to customers who are not paying or has aggressive revenue-recognition policies. If either of these occurs, we should expect a future charge to reduce income as the low-credit-quality customers cannot pay their bills or the revenue-recognition policy is changed. Some of the more popular frauds involve companies shipping merchandise to consumers that was never ordered and recording the shipment as a sale. This is called channel stuffing. When channel stuffing occurs, we see a large spike in accounts receivable. Investors should look for the ratio of accounts receivable growth to sales growth to be negative as it indicates receivables is growing slower than sales and the company is generating cash from its operating business.
2. Property, plant, and equipment (PPE) as a percent of total assets – PPE represents long-term assets that a company uses to run its business. For Ford the PPE would be a factory and for Goldman Sachs an office building. The ratio of PPE to total assets should be relatively steady over time. Large variances in either direction indicate something is amiss. For example, if we see a large spike in this ratio, it may indicate that a company is capitalizing routine maintenance costs. This pattern was a key part of WorldCom’s accounting fraud. Conversely, a declining ratio may show that a company is not investing in its core business. Were this to occur business is likely to suffer in the future.
3. Accounts payable versus sales growth – When a company receives goods and services, it promises to pay for them at a future date. This promise creates an account payable. If we see accounts payable growing faster than sales, it indicates the company is delaying payment for the goods it receives. At some point in the future, there will be a cash outflow to pay for these goods and the balance sheet will weaken. Investors should expect the ratio of accounts payable to sales growth to be negative, as ballooning accounts payable indicate future cash outflow.
4. Cost of goods sold (COGS) as a percent of sales – COGS represents what a company pays for the inventory it then sells to customers. We should expect the relationship between COGS and sales to be relatively stable as companies adjust their business strategies to market expectations. A large variation in this relationship could indicate accounting irregularities.
5. Operating cash flow versus earnings per share (EPS) – GAAP accounting intends to match expenses with revenue. If a company buys inventory it does not take the cost as an expense when the inventory is paid for. Instead, GAAP allows the expense to match the revenue, and recognizes the expense when the item is sold. In theory, this reduces volatility. However, it also creates differences between cash flow and EPS. When the inventory was paid for, cash went out the door and cash flow declined with no effect on EPS. Over time, we should expect this difference to disappear as accounting cycles converge. However, investors should examine the difference as a means of detecting earnings’ quality. If EPS consistently exceeds operating cash flow, it indicates poor earnings quality. Companies with poor earnings quality make poor investments.
These warnings signs are very helpful to investors. When something is awry it does not mean a fraud has occurred, but it does warn us to pay attention. Companies flashing accounting warning signs typically have subpar performance over coming quarters.
Sean Hannon, CFA, CFP is a professional fund manager.