Question

What financial ratio might provide warnings about possible channel stuffing?

Answer 1

Channel stuffing is a business way to swell illusory sales and earnings figures used by the companies. They do it by supplying more of their products to the distribution channel and they understand distribution channel will not be able to sell it to the public.

This method is generally used before quarter end or yearend so that management could present data in accordance with their wishes to save them from negative impacts on their payouts.

There are few ratios which can indicate Channel stuffing:

1. AR Growth Vs. Sales Growth: This ratio compares the Account Receivable with Total sales of the organization. If the AR is increasing faster than the total sales, it could be an indication that Company is selling its product to the customers on credit who are not paying or company has aggressive policy of revenue recognition.
2. AP Growth Vs. Sales Growth: This ratio compares the Account Payable with Total sales of the organization. If the AP is increasing faster than the total sales, it could be an indication that Company is delaying the payment against credit purchases to present good cash in hand in companies’ books. But it could be an alarming situation because some point of time we must make the payment and it will impact the Balance Sheet.
3. Operation cash Vs EPS: As per GAAP accounting intends to match expenses with revenue. company acquire inventory and might not include the cost as an expense at the time of inventory is paid for but at the time of sale. Instead, as per GAAP inventory purchases included in expenses only when the item is sold. Theoretically, it lowers unpredictability. but, it produces differences between cash flow and EPS. Over the duration of time, this difference should disappear as accounting cycles converge. However, investors should examine the difference as a means of detecting earnings’ quality. But if Earning per share constantly surpasses operating cash flow, it means weak earnings quality. Companies with lowly earnings quality attract weak investments.