Irrational Ratios in the Companies Financial Statements

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Introduction

Changes in the financial performance of an entity from one period to another period depend on a number of factors. These factors are economic (such as fluctuations in the exchange rate, stiff competition and recession), social (such as people’s perception about the product), and climatic factors (adverse weather changes such as drought and constant snow flow) (Vance, 2003). Therefore, an institution should closely monitor the effects of internal and external factors on financial statements (Haber, 2004). Companies are required to publish financial statements for use by various stakeholders. Therefore, it is necessary to analyze the financial performance of a company because it gives stakeholders an understanding of the financial records. Ratio analysis is a vital tool for analyzing the financial performance of a company (Siddiqui, 2005).

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Irrational ratios

Profitability, liquidity, leverage, and efficiency ratios are efficient in monitoring the performance of an institution over time. However, these ratios may not provide information on the possibility of manipulation of the financial records. Irrational ratios provide an in-depth insight into the financial performance of a company. They show the possibility of manipulation of financial statements. They also indicate the possibility of fraud. Financial statements such as cash flow statements, statement of financial position, and statement of profit and loss are interrelated. Therefore, it might be impossible to detect any irregularities in the statements using simple ratios (Brigham and Houston, 2009). Irrational ratios reveal any irregularities that exist in the financial statements. Manipulators mean index and non-manipulators index used to carry out hypothesis testing on the ratios computed. The Wilcoxon Rank Sum and Median tests reveal whether there is an existence of fraud in the financial statements. The commonly used irrational ratios are days in sales receivables index, gross margin index, asset quality index, sales growth index, and accruals to total assets (Wells, 2001). This paper attempts to compute irrational ratios for five companies such as HealthSouth, Dell Computers, Overstock.com, Marks and Spencer, and Coca-Cola Company. It further carries out hypothesis tested on the results showing possible existence of fraud in the financial statements of the five companies.

Overview of irrational ratios

Days’ Sales in receivables index

“This ratio measures whether receivables and revenue are in or out of balance in conservative reporting periods” (Wells, 2001). A substantial increase in the value of the index can be an indication that receivables are spurious.

Gross margin index

Gross profit is a reliable indicator of a company’s health. “When an entity’s gross profit margins on sales shrink from one period to the next, the risk is high that management will engage in fraud to create artificial profits or decrease losses” (Wells, 2001). Therefore, a financial analyst should look for significant changes in the gross profit index.

Asset quality index

Asset quality index measures “the proportion of total assets for which future benefits may be less certain” (Wells, 2001). An upward trend in the asset quality index shows a possibility of capitalization of costs in the future.

Sales growth index

The sales growth index helps investigators to know whether growth in sales of a company is justifiable or not. Results of hypothesis testing will enable an investigator to determine whether the growth in sales is genuine.

Total accruals to total assets index

The total accruals to total assets index indicate the possibility of the use of accrual policy to manipulate earnings. “An increase in accruals from one period to the next may indicate that management is attempting to manipulate earnings through its discretionary authority over accrual policy” (Wells, 2001).

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HealthSouth Corporation

About the company

HealthSouth, founded in 1984, is a publicly-traded company incorporated in the United States. It offers inpatient rehabilitative services in about 26 centers within America.

Table 1.0 Irrational ratios for Health South Corporation.

2000 2001 2002
Days in sales receivable index 0.941477095
no
0.819863174
no
0.93006985
No
Gross margin index 1.116527706
possible
0.778220211
no
1.019503778
Possible
Asset quality index 1.007830267
no
1.016249494
no
1.037754969
No
Sales growth index 1.015496868
no
1.114573169
no
0.999359114
no
Accruals to total assets 0.156571505
Yes
0.215053289
Yes
0.261054254
Yes

Explanation of the results

From the above table, the total accruals to total assets index show that the company manipulated earnings using accrual policy. Also, the gross profit index shows a possibility of manipulation of the gross profit of the company.

Dell Computers

About the company

Dell Computers is a multinational company incorporated in the United States of America. The Company engages in the development, sales and support of computers. Michael Dell founded the company in 1984. The company employs over 100,000 citizens. It has recorded tremendous growth over the years since its formation.

Table 1.1 Irrational ratios for Dell Computers.

2004 2005 2006
Days in sales receivable index 1.200788615
possible
0.825588882
no
1.010035336
no
Gross margin index 0.984130471
no
0.994589389
no
1.029455008
Possible
Asset quality index 1.116951224
possible
0.537479496
no
0.737753724
no
Sales growth index 1.170602192
possible
1.187264743
possible
1.136225993
possible
Accruals to total assets -0.087514888
No
0.025629981
possible
-0.082695054
no

Explanation of the results

The table above shows that there was a possibility of manipulation of earnings during the three years. Investigators need to carry out more analysis to verify if there were actual manipulations of earnings.

Overstock.com

About the company

Overstock.com founded in 1997, is an American-based company. The company carries out online trading, auctioning and advertisement among others.

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Table 1.2 Irrational ratios for Overstock.com.

2008 2009 2010
Days in sales receivable index 0.57519075
no
1.57725162
yes
0.937164872
No
Gross margin index 0.935613451
no
0.924971949
no
1.079919682
possible
Asset quality index -6.131882878
no
-0.83050752
no
-0.427830139
no
Sales growth index 1.083493711
no
1.056539134
no
1.243056039
possible
Accruals to total assets 0.134341801
yes
-0.081496776
possible
0.274808236
Yes

Explanation of the results

The table above shows that there was manipulation of earnings in 2004 as indicated by the day’s sales receivable index. Besides, the company also made use of an accrual policy to manipulate earnings during the three years. There was an indication of manipulation of financial reports for the year 2010 because most of the ratios show the possible existence of manipulation.

Marks and Spencer

About the company

Marks and Spencer is an international company having several stores in the United Kingdom. The Company deals with clothing and food products. It is a publicly-traded company. Michael Marks and Thomas Spencer founded the company in 1884.

Table 1.3 Irrational ratios Marks and Spencer.

2008 2009 2010
Days in sales receivable index 1.488593921
Yes
0.923075369
no
0.937583283
No
Gross margin index 0.907077043
no
1.397362873
yes
1.075458525
Possible
Asset quality index 1.955316097
possible
-32.85312256
no
-0.021767205
No
Sales growth index 1.050523399
no
1.004444691
no
1.052360932
No
Accruals to total assets -0.178955453
no
-0.292266571
no
-0.282419057
no

Explanation of the results

The management of the company manipulated earnings over the three-year period. This is shown by days in the sales receivable index in 2008 and gross margin index in 2009 and a possibility in 2010.

Coca-Cola

About the company

Coca-Cola founded in 1886, deals in soft drinks. It is a multinational company incorporated in the United States of America. The company owns several brand names.

Table 1.4 Irrational ratios for Coca Cola Company.

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2008 2009 2010
Days in sales receivable index 1.070282947
Possible
0.841540245
no
1.253620303
Possible
Gross margin index 1.033909908
possible
0.992941666
no
1.002697308
No
Asset quality index 1.213823163
possible
0.878217137
no
0.726616159
no
Sales growth index 1.197982398
possible
1.106975777
no
0.970135237
No
Accruals to total assets -0.096928517
no
-0.071571362
No
0.000205461
No

Explanation of the results

From the table above, the results of hypothesis testing indicate that the company did not manipulate earnings. However, there were possibilities of manipulation especially in 2008 and 2009. Therefore, an investigator needs to carry out more tests to enable him to verify the existence of manipulation of the financial statements.

Conclusion

Irrational ratios were computed for five companies. The results indicate the companies manipulated or showed indications of manipulating earnings within the period of analysis. Manipulation of earnings is a common practice across the globe. Accountants easily manipulate financial records. Fraud is difficult to detect. An investigating body needs to be well informed on matters concerning fraud especially on ways which accountants use to conceal the fraud. An investigator can also use vertical and horizontal analysis to detect fraud. It is necessary to carry out an investigation over the period.

References

Brigham, E., & Houston, F. (2009). Fundamentals of financial management. USA: South-Western Cengage Learning.

Haber, R. (2004). Accounting dimistified. New York: American Management Association.

Siddiqui, A. (2005). Managerial economics and financial analysis, New Delhi: New age international (P) limited.

Vance, D. (2003). Financial analysis and decision making: Tools and techniques to solve. United States: McGraw-Hill Books

Wells, J. (2001). Irrational ratios. Web.

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BusinessEssay. 2022. "Irrational Ratios in the Companies Financial Statements." April 29, 2022. https://business-essay.com/irrational-ratios-in-the-companies-financial-statements/.

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BusinessEssay. "Irrational Ratios in the Companies Financial Statements." April 29, 2022. https://business-essay.com/irrational-ratios-in-the-companies-financial-statements/.