Question

Can ratios help management uncover fraudulent activity within the company? How? Please give an example.

Answer 1

Financial analysis techniques can help investigators discover and examine unexpected relationships in financial information. These analytical procedures are based on the premise that relatively stable relationships exist among economic events in the absence of conditions to the contrary.

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:

a. Accounts receivable growth vs sales growth

b. Property, plant, and equipment (PPE) as a percent of total assets

c. Accounts payable versus sales growth

d. Cost of goods sold (COGS) as a percent of sales

e. Operating cash flow versus earnings per share (EPS)

Example Using Current Ratios:

If current ratio for year1 is 2.84 & year 2 is 1.70.

The number of times that current assets exceed current liabilities has long been a measure of financial strength.

In detecting fraud, this ratio can be a prime indicator of manipulation of accounts involved. Embezzlement will cause the ratio to decrease. Liability concealment will cause a more favorable ratio.

In the preceding example, the drastic change in the current ratio from year 1 (2.84) to year 2 (1.70) should cause an examiner to look at these accounts in more detail. For instance, a check-tampering scheme will usually result in a decrease in current assets, cash, which will in turn decrease the ratio.