Advanced Forensic Financial Analysis

To stay ahead of financial statement fraud, fraud examiners must step up to a new level of analytical comprehension and intellect to uncover the latest devious techniques.

(This article is reprinted with permission from the June 2001 issue of National Association of Credit Management's Business Credit magazine.)  

Financial statement fraud is "a new kid on the block," and the intent to conceal and take advantage by false suppression of the truth of assets, liabilities, cash flow, sales and profitability is creating a new level of risk for corporate America. Fraud examiners must have a new level of analytical comprehension and intellect to uncover the devious techniques.

The threat of financial fraud has greatly impacted the corporate community worldwide. The fraud examiner of the future must also be able to cope with the adverse conditions related to Initial Public Offerings (IPOs), mergers, recapitalization, leverage buyouts, chapter 11 bankruptcies, and economic turmoil and volatility. Those companies falling into the category of high risk are affected by the following conditions:

Weak Solvency - weak liquidity ratio

s, highly leveraged condition, and overcapitalization.

Weak Efficiency - slow turnover of accounts receivable, accounts payable, and inventory, or substantially inadequate cash flow/working capital to sustain growth and/or reinvestment.

Weak Profitability - deviations in profitability or unprofitability.

Dealing with these conditions requires a fraud examiner with a diverse level of experience and knowledge in the field of advanced financial and economic risk analysis. Analyzing at that level is commonly referred to as forensic financial analysis. This methodology can be utilized when analyzing high-risk customers, and vital suppliers, and for minimizing the potential of financial fraud.

The use of bank reference information is also important when assessing the financial condition and credibility of corporations. When sending the bank reference letter to a bank officer, include a section that requires his signature and date. However, before sending the bank reference letter to the bank officer, obtain a prior written or verbal approval from the customer or supplier/vendor to secure answers to these questions:

• What is the length of the borrowing relationship?
• What are the years of experience?
• What is the high credit?
• What are the types of loans?
• What is the rate of financing?
• What is the current balance?
• Is financing secured?
• Have loan covenants been amended?
• Is the company in compliance with loan covenants?
• What are the restrictive covenants?

During the analysis and investigative phase, perform the following statistical and subjective assessments:

• Perform financial and ratio trending analysis to determine dramatic deviations. Analyze the statistics for condition and trending inconsistency.
• Use industry and economic standards to assist in determining level of condition and trend. Assess the condition factoring in industry statistics.
• Industry statistics can also be skewed, which may result in inaccurate comparative standards. Analyze the ratio results to determine irregular deviations.
• Utilization of bankruptcy risk and cash flow analysis is imperative to determine level of risk. Analyze the z-score (bankruptcy prediction system) and cash flow analysis to determine if their conditions fall in sync with the financial condition.
• Evaluate contingencies to determine if the potential of material impact exists. Footnotes must be evaluated to determine if the financial condition will be impacted.
• Is the company in compliance with the credit agreement? Evaluate the rate of financing - this process is critical because it determines the level of risk to the banking community.
• Investigate and assess footnotes for previous or current indictments of criminal fraud. Adequate footnotes will provide notes related to contingencies or litigations related to criminal fraud.
• Be concerned about substantial suits, liens, or judgments, which could have material impact on the company. The quantity and dollar level of suits, and judgments must be evaluated to determine if the threat of material impact exists.Subjective analysis is another critical phase of the process.

Drastic deviations in payment habits with suppliers over the short- and long-term, may be an indication that cash flow problems exist or there's a potential of bankruptcy or fraud. Therefore, it's necessary to monitor payment habits to suppliers for a period of three to five years. Request a change in credit reference every three years to verify if drastic changes exist in payment habits. A company in business less than three years has a higher probability of bankruptcy or fraud. Antecedent information from a D&B report will give background information regarding the history and operations of the company, as well as the background history of the corporate officers. Also be concerned about resignations or changes in executive management.
The analysis or investigative process requires a detailed horizontal and vertical trending relationship assessment of the following financial statistics and information:

• Historical analysis of the Balance Sheet and Income Statement
• Ratio trending analysis
• Common sizing historical statistics by percentages
• Comparative analysis by industry standards
• Cash flow trending analysis

The following reflects a strategic assessment of the P&L to determine the weaknesses or strengths:

• Assess the trending consistency of net sales, gross profit, operating income, and net income.
• If net sales increased or decreased, determine what factors impacted the changes. Were the changes impacted by business strategy, deteriorating financial condition, economic problems, manufacturing deficiencies, lack of upgraded technologies, or competition?
• Decipher the positive or negative condition of gross profit and operating profit margin, and the factors that affected this level of performance. Determine if gross margin was impacted by competition, product pricing, level of sales, and/or inventory valuation. Was the operating profit impacted by restructuring charges, reorganization, interest expense, or non-recurring charges?
• Analyze the EBIT (earning before interest and tax)/interest expense ratio to determine the trending results, and verify that the results exceed the bank compliance requirements, and/or the ratio exceeds 1.00.
• Evaluate the net income trend before and after tax to determine if level of sales, competitive industry and pricing, effective management of operations, reorganization and/or restructuring charges, and interest expenses impacted profitability or unprofitability.

Thoroughly evaluating the Profit and Loss Statement is just the beginning phase of financial analysis. After completing the assessment of the negative and positive aspects of the P&L, evaluate the Balance Sheet to determine the ratios and financial statistics that substantiate your analytical conclusions.

Critical Conditions That Impact the Profit and Loss Statement
Net Sales ------------------------------------------Percent of Change
Factors Impacting Change
Competition
Economics
Technological advantages or disadvantages
Terms

Cost of Sales -------------------------------------- Percent of Change

Increased inventory
Inventory valuation for tax purposes (increases/decreases)
Economics
Sales management strategy (success/failure)

Gross Profit --------------------------------------- Percent of Change

Competition
Economics
Technological advantages or disadvantages
Sales management strategy (success/failure)
Terms (negotiated terms)
Manufacturing

Net Profit ----------------------------------------- Percent of Change

Competition
Economics
Technological advantages or disadvantages
Sales management strategy (success/failure)
Terms (negotiated terms)
Manufacturing
Interest expense
Extraordinary charges (restructuring or reorganization)
Changes in prime interest rate
Lawsuit(s) or litigation(s)
Inventory writedowns (Write off of slow-moving Inventory)

This is a critical phase of analysis, because it's the beginning process of differentiating problems with the Balance Sheet and cash flow statement. The P&L will also assist as an indicator for determining weaknesses or strengths. Bringing your analysis skills to a higher level requires a comprehension of the P&L statement, Balance Sheet, cash flow analysis, and footnotes.

Both working capital and cash flow are also two critical components that are interrelated. Your knowledge and ability to extract those negative conditions will assist you in forensic analysis. Working capital is impacted by the turnover of accounts receivable, inventory, and its relationship with accounts payables and short-term debt. Cash flow is impacted by dramatic increases or decreases in short- and long-term debt, financing rates, interest expenses, turnover of accounts receivable, accounts payable, inventory, and changes in capital investments into fixed assets.

Don't always assume that a low probability of risk exists with companies that initiate an IPO, recapitalization, or cash infusion. The following are some guidelines you can use to analyze a corporation that falls into those categories:

• Monitor the changes in short- and/or long-term debt. It's a common business practice for a company to pay down the debt obligation. Caution should be exercised if the bank debt doesn't change.
• Accounts payable turnover should improve because of the improved cash flow. Be concerned if the turnover stays the same or increases because this may be an indication that cash flow is being diverted for benefits other than for business use.
• If inventory turnover is faster than normal, then both sales and cash flow should reflect an improved condition. Be concerned if sales increase and inventory turnover decreases. Also, be concerned if sales decrease and inventory turnover increases. These conditions may be indicative of a company that manipulates their results.
• Net worth should increase as a result of an IPO or cash infusion. This should ultimately result in a change in the equity position, and debt-to-equity ratio. Be concerned if the debt position increases, and accounts payable, accounts receivable, and inventory reflect a slower than normal turnover or increase. This may be an indication of changes in the financial condition, management manipulating the books, or financial fraud.

Analyzing the Balance Statement is critical in verifying the weaknesses and strengths of a corporation. Trending analysis of the financial statistics and ratios should be utilized to substantiate your condition and trend assessment. Continue to monitor the trending differentials, and be concerned about dramatic changes in the turnover of accounts receivable, accounts payable, inventory and net worth. Dramatic changes in trending statistics should considered a red flag, and should be monitored quarterly and annually to verify changes in deviations. When dramatic changes in turnover occur, it's imperative that further investigation is necessary to determine the factors that influenced the changing conditions. Relationship trending analysis should be used as a critical tool for distinguishing changes in conditions and trends. As a rule of thumb, a red flag must go up if a logical business explanation cannot be determined. This could be an indication of substantial risk, which could result in the probability of bankruptcy or fraud. The following reflects the impact of changes in the Balance Sheet:

Net WorthA decreased or deficit net worth can be attributed to a trend of unprofitability, and deduction of intangibles due to goodwill, patents, franchises, copyrights, and cost in excess of market value. Monitor the trending pattern of retained earnings and net worth after IPOs, cash infusions, and profitability.
Accounts Payable

Be cautious with a company that has a high accounts payable or slow turnover. This condition indicates that the company is using other suppliers to finance operations. A red flag should go up when no bank financing vehicles exist and accounts payable is excessive or turnover is slow. Also, be concerned if the financing rate is excessive, which may indicate that the company is a risk to the banking community. These are all indicators of weak cash flow, and high probability of financial risk that could result in bankruptcy or fraud.

LT Debt
Be concerned about excessive borrowing, and evaluate the level of accounts payable in conjunction with tangible net worth. Evaluate the financing rate, and verify that they are in compliance with the credit agreement. A red flag should go up if they are in default of the credit agreement, or they continue to obtain waivers. Be concerned if the condition is highly leveraged, sales are down, and condition is unprofitable.

Fixed Assets
Excessive investments into fixed assets could put a strain on cash flow, working capital, and future sales growth. Be concerned if the fixed assets/net worth ratio exceeds 80 percent. A red flag should go up if cash flow and working capital are weak, and turnover of accounts receivable, inventory, and accounts payable are slow according to industry standards. Also, monitor the gross margin trend to verify if decreased sales and excessive inventory levels are impacting gross profit.

Current Ratio
Evaluate the quick ratio, accounts receivable, and inventory turnover in conjunction with the current ratio to determine the overall liquidity position. A false impression can be created if the current ratio is solely used as an indicator for determining the liquidity position.

Total Debt/Equity
This ratio is critical because it measures the relationship between the creditor interest and tangible net worth. The higher the debt in relation to equity, the more leveraged the condition. If a highly leveraged condition exists, then cash flow, level of debt, interest expense, and verification of bank compliance should be monitored annually.

Fixed Assets/Net Worth
This ratio is important when evaluating the liquidity position of a company. Be cautious if the ratio is greater than 80 percent, which may indicate a heavy investment into fixed assets. The lack of cash flow or limited financing could put restrictions on future development and growth. Creditors could also be impacted by slow payment to suppliers, which could put them in default of the credit agreement.

(To be continued in the November/December issue of The White Paper.)

Michael F. Rosplock, CFE, is a senior financial analyst with Corning Incorporated.