CHAPTER 5

IDENTIFICATION OF KEY FINANCIAL RATIOS

CHAPTER 5
IDENTIFICATION OF KEY FINANCIAL RATIOS FOR PREVENTION
AND DETECTION OF FINANCIAL STATEMENT FRAUD

5.1 Introduction
5.2 Financial Statements
5.2.1 Balance Sheet
5.2.2 Income Statement
5.2.3 Cash Flow Statement
5.3 Key Financial Ratios for Detection of Financial Statement Fraud
5.3.1 Financial Ratios
5.3.2 Variables related to Detection of Financial Statement Fraud
5.4 Behavioural Characteristics For Preventing Fraudulent Financial Reporting
5.5 Summary

5.1 INTRODUCTION
The business of financial statement fraud present a substantial cost to our economy
worldwide. Companies are constantly identifying new and ingenious way to defraud their
customers, investors, the government and others. The parties who have an interest in a
company do not only want to see the company prosper in terms of exceptional financial
performance and a strong financial position. They also want to see the company display a
strong presence in the market and a positive image in the media. For this reason, ethical
behaviour is essential. It is, however, difficult for people both in and outside a company to
determine whether a company, through its employees and management, displays satisfactory
ethical behaviour and does not engage in activities that can increase a company's accounting
risk and create the possibility of financial fraud occurring [Toit08].

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The values and numbers present in financial statements can be easily interpreted with the help
of different financial ratios. Financial ratio assists investors / auditors in evaluating the actual
position of the company.
Therefore, capital market participants should observe and measure the financial ratios and
behavioural characteristics in order to prevent and detect financial statement fraud.
This chapter recognize the financial ratios and behavioural characteristics from published
financial results for prevention and detection of financial statement fraud. This chapter is
organised as follows: Section 5.2 explain the nature and function of different financial
statements i.e. balance sheet, income statement and cash flow statement. Section 5.3 provides
a list of key financial ratios to be used as input vector for detection of fraudulent financial
reporting. This section also explains different performance measures required for analysing
the actual financial status of an organisation. Section 5.4 explores financial variables related
to behavioural characteristics for prevention of financial statement fraud followed by
Summary of the chapter (Section 5.5).
5.2 FINANCIAL STATEMENTS
Financial statements are a company's basic documents to reflect its financial status
[Beaver66]. A careful reading of the financial statements can indicate whether the company is
running smoothly or is in crisis. If the company is in crisis, financial statements can indicate
if the most critical thing faced by the company is cash or profit or something else. All the
listed companies are required to publish their financial statements every year and every
quarter. The stockholders can form a good idea about the companies financial future through
the financial statements, and can decide whether the companies stocks are worth investing.
The bank also needs the companies financial statements in order to decide whether to grant
loans to them. In a nutshell, the financial statements are the mirrors of the companies
financial status.
Financial statements are records of financial flows of a business. Generally, they include
balance sheets, income statements, cash flow statements and some other statements. A brief
description of the items listed in the various financial statements is given below:
5.2.1 BALANCE SHEET
A balance sheet is a statement of the book value of an organization at a particular date,
usually at the end of the fiscal year. A balance sheet has three parts: assets, liabilities, and
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shareholders' equity. The difference between the assets and the liabilities is known as the 'net
assets' or the 'net worth' of the company.
5.2.2 INCOME STATEMENT
Income statements, also called Profit and Loss Statement for companies indicate how net
revenue (money received from the sale of products and services before expenses are
subtracted, also known as the top line) is transformed into net income (the result after all
revenues and expenses have been accounted for, also known as the bottom line). The
purpose of the income statement is to show managers and investors whether the company
made or lost money during the period under consideration.
5.2.3 CASH FLOW STATEMENT
A cash flow statement is a financial statement that shows incoming and outgoing funds
during a particular period. The statement shows how changes in balance sheet and income
accounts affect cash and cash equivalents. As an analytical tool the statement of cash flows is
useful in determining the short-term viability of a company, particularly its ability to pay
bills.
5.3 KEY FINANCIAL RATIOS FOR DETECTION OF FINANCIAL STATEMENT
FRAUD
Financial statement fraud may be perpetrated to increase stock prices or to get loans from
banks. It may be done to distribute lesser dividends to shareholders. Another probable reason
may be to avoid payment of taxes. Nowadays an increasing number of companies are making
use of fraudulent financial statements in order to cover up their true financial status and make
selfish gains at the expense of stockholders. Financial Ratios are the key factors in detection
of financial statement fraud because they present a clear picture of financial health of an
organisation. A detailed description of financial ratios is given below:
5.3.1 FINANCIAL RATIOS
Financial ratios are a valuable and easy way to interpret the numbers found in financial
statements. They can help to answer critical questions such as whether the business is
carrying excess debt or inventory, whether customers are paying according to terms, whether
the operating expenses are too high, and whether the company assets are being used properly
to generate income.
5.3.1.1 LIQUIDITY
Liquidity measures a company's capacity to pay its liabilities in short term. There are two
ratios for evaluating liquidity. They are:
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1) Current ratio=Total current assets/ Total current liabilities

2) Quick ratio= (Cash+ Accounts receivable + Any other quick assets) /Current liabilities
The higher the ratios the stronger is the company's ability to pay its liabilities as they become
due, and the lower is the risk of default.
5.3.1.2 SAFETY
Safety indicates a company's vulnerability to risk of debt. There are three ratios for evaluating
liquidity. They are:
1) Debt to equity=Total liabilities /Net worth
2) EBIT/Interest=Earnings before interest and taxes/ Interest charges
3) Cash flow to current maturity of long-term debt= (Net profit + Non-cash
expenses)/Current portion of long-term debt
5.3.1.3 PROFITABILITY
Profitability ratios measure the company's ability to generate a return on its resources. There
are four ratios to evaluate a company's profitability.
They include:
1) Gross profit margin=Gross profit / Total sales
2) Net profit margin=Net profit / Total sales
3) Return on assets=Net profit before taxes/ Total assets
4) Return on equity=Net profit before taxes/Net worth
5.3.1.4 EFFICIENCY
Efficiency evaluates how well the company manages its assets. There are four ratios to
evaluate the efficiency of asset management:
1) Accounts receivable turnover=Total net sales /Accounts receivable
2) Accounts payable turnover=Cost of goods sold/Accounts payable
3) Inventory turnover=Cost of goods sold/Inventory
4) Sales to total assets=Total sales /Total assets
5.3.2 VARIABLES RELATED TO DETECTION OF FINANCIAL STATEMENT
FRAUD
On the basis of existing academic research and experts knowledge, the following financial
variables / ratios are identified for detecting fraudulent financial reporting.
5.3.2.1 Z-score
Financial distress may be a motivation for management fraud. To measure the financial
distress Z-score is developed by [Altman68]. It is a formula for estimating the financial status
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of a company and also helpful in bankruptcy prediction. The formula for Z-score for public
companies is given by:
Z-score= (Working capital / Total assets* 1.2) + (Retained earnings Total assets* 1.4) +
(Earnings before income tax Total assets* 3.3) + (Book value of total / Liabilities * 0.6) +
(Sales Total assets* 0.999)
5.3.2.2 High debt structure
A high debt structure may be an indicator for fraudulent financial reporting, because it shifts
the risk from mangers to debt owners. Hence, the higher levels of debt may increase the
likelihood of financial statement fraud and one should carefully consider the financial ratios
related to debt structure. This can be measured by using logarithm of Total Debt, the Debt to
Equity ratio and the Total Debt to Total Assets ratio.
5.3.2.3 Continues growth
The need for continues growth may be another motivational factor for financial statement
fraud [Albrecht91]. So, sales to growth ratio should be measured as a fraudulent financial
statement indicator.
Sales to growth = (Current Year's sales - Last Year's sales) / (Last Year's sales)
5.3.2.4 Other items
A number of accounts, which permit a subjective estimation, are more difficult to audit and
thus are prone to fraudulent falsification: Accounts Receivable, Inventory and Sales fall into
this category. The fraudulent activity of recording sales before they are earned may show up
as additional accounts receivable. Accounts Receivable has been checked by using the ratio
Account Receivable / Sales. A company may manipulate accounts receivable, inventories and
gross margin. Accounts receivable may be manipulated by recording sales before they are
earned. Inventory is also prone to manipulation. Mangers may manipulate inventory either by
reporting inventory at lower cost or by obsolete inventory or both. Inventory has been
measured by using the ratios Inventory / Sales and Inventory to Total Assets. A company
may use gross margin as a factor for falsifying financial statement. The company may not
match its sales with the corresponding cost of goods sold, thus increasing gross margin, net
income and strengthening the balance sheet. Gross Margin is being tested by using the ratio
Sales minus Gross Margin, the ratio Gross Profit / Total Assets.
A number of additional financial ratios such as deposits and cash / current assets, Net Profit /
Total Assets, Working Capital / Total Assets, Net Profit / Sales, working capital, the ratio of
property plant & equipment (net fixed assets) to total assets, sales to total assets, Current
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Assets /Current Liabilities, Net Income / Fixed Assets, Cash / Total Assets, Quick Assets /
Current Liabilities, Earnings Before Interest and Taxes (EBIT) and Long Term Debt / Total
Assets (LTDTA) are taken into account for financial statement fraud detection.
Table 5.1 presents a list of financial variables / ratios that are to be tested in relation to their
ability of detecting financial statement fraud.

Table 5.1: Financial Variables / Ratios for Detection of Financial Statement Fraud
S. No.

Financial Variables / Ratios

Debt

2.

Total assets

Gross profit

Net profit

Primary business income

Cash and deposits

Accounts receivable

Inventory/Primary business income

Inventory/Total assets

10

Gross profit/Total assets

11

Net profit/Total assets

12

Current assets/Total assets

13

Net profit/Primary business income

14

Accounts receivable/Primary business income

15

Primary business income/Total assets

16

Current assets/Current liabilities

17

Primary business income/Fixed assets

18

Cash/Total assets

19

Inventory/Current liabilities

20

Total debt/Total equity

21

Long term debt/Total assets

22

Net profit/Gross profit

23

Total debt/Total assets

24

Total assets/Capital and reserves

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S. No.

Financial Variables / Ratios

25

Long term debt/Total capital and reserves

26

Fixed assets/Total assets

27

Deposits and cash/Current assets

28

Capitals and reserves/Total debt

29

Accounts receivable/Total assets

30

Gross profit/Primary business profit

31

Undistributed profit/Net profit

32

Primary business profit/Primary business profit of last year

33

Primary business income/Last year's primary business

income

34

Account receivable /Accounts receivable of last year

35

Total assets/Total assets of last year

36

Debit / Equity

37

Accounts Receivable / Sales

38

Inventory / Sales

39

Sales Gross Margin

40

Working Capital / Total Assets

41

Net Profit / Sales

42

Sales / Total Assets

43

Net income / Fixed Assets

44

Quick assets / Current Liabilities

45

Revenue /Total Assets

46

Current Liabilities / Revenue

47

Total Liability / Revenue

48

Sales Growth Ratio

49

EBIT

50

Z Score

51

Retained Earnings / Total Assets

52

EBIT / Total Assets

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5.4 BEHAVIOURAL CHARACTERISTICS FOR PREVENTING FRAUDULENT

FINANCIAL REPORTING
In the process of financial statement fraud prevention and detection, internal and external
auditors have to play a major role, but they cannot be held solely responsible for detection
and identification of financial statement fraud. Auditing Profession Act 26 (2005) defines
audit as the examination of financial statements in accordance with applicable auditing
standards with the objective of expressing an opinion as to their fairness and compliance with
a financial reporting framework and any applicable statutory requirements.
A well balanced functioning system of corporate governance is responsible for high quality
financial reports, including reliable financial statements free of material misstatements caused
by errors and fraud. Corporate governance system comprise of six groups: the board of
directors, the audit committee, the top management team, internal auditors, external auditors
and governing bodies including the Securities and exchange commission, financial auditing
standard boards, state authorities, stock exchange and financial institution regulatory agencies
[Razaee02]. The following behavioural characteristics should be taken into consideration for
preventing financial statement fraud [Toit08]. (Table 5.2)
Table 5.2: Behavioural Characteristics for Fraud Prevention
S. No.

Characteristics

1.

Parameters to be analysed
1. Complex Accounting practices and transactions

Accounting transactions
2. Significant related-party transactions.
2.

1. Frequent changes of auditors.

2. Strained relationship between management and
auditors.
Auditors

3. Attempts to influence auditors.

4. Disputes with auditors.
5. Withholding information from auditors.

3.

Cash flow

1. Poor cash flow, especially in relation to profit.

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4.

Company age

5.

Control

6.

7.

Culture

Debt

8.

1. How old are the Company?

1. A poor/weak control environment.
1. A lack of documentation to formalize processes
(e.g. code of conduct, ethics policy, fraud policy).
1. Tendency to have higher debt.
1. Few outsiders on the board of directors.

Directors
2. Status of audit committee.
9.

Financial distress

1. The presence of high financial pressure

10

Geographic location

1. Centralized or Decentralized company.

11.

1. Type of industry (Volatile) where changes (e.g.

technology) are frequent and significant.
Industry

2. A high level of competition.

3. Economic factors.

12

Liquidity

13.

1. Good or poor liquidity.

1. Autocratic or dominant management team
makes unethical behaviour by management easier.

Management

2. Management turnover (High or Low)

3. Conflict of interests.
4. Shorter-term / Longer term) performance.

14.

1. Rapid turnover of personnel.

Personnel

15.

Receivables and inventory

16.

Shareholding

2. Lavish lifestyles of personnel, especially

management.
1. Increases in receivables and/or inventory.
1. High levels of internal shareholding (by
management and/or directors).

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On the basis of behavioural characteristics mentioned above, the financial variables / ratios
mentioned in Table 5.3 are selected for preventing fraudulent financial reporting. These
variables in addition to the variables given in Table 5.1 are used as input vector to the
proposed framework for prevention along with detection of financial statement fraud.

Table 5.3: Financial Ratios for Prevention of Financial Statement Fraud

S. No.

Financial Ratios

1.

Total Liabilities / Total assets

2.

Cash return on assets

3.

Interest expense / Total Liabilities

4.

EBIT / sales

5.

Age of the company (Number of years since first filing

available from provider)

6.

Change in cash scaled to total assets

7.

Change in current assets scaled by current liabilities

8.

Change in total liabilities scaled by total assets

9.

Size of company on the basis of assets

10.

Size of company on the basis of revenue

5.4 SUMMARY
Financial statement consists of numbers to represent the financial status of the organisation.
These numbers (financial ratios / variables) represents the actual financial standing of a
company to the capital market participants. An investor has to take a wise decision regarding
investment on the basis of profitability, liquidity, safety and efficiency represented by these
financial variables. Any type of falsification of these numbers of financial statement is termed
as financial statement fraud.
This chapter identifies key financial variables effective for prevention and detection of
financial statement fraud. Prevention of financial statement fraud is a measure to stop its
occurrence initially, whereas detection means the identification of such fraud as soon as
possible.

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Fraud detection is required only if prevention has failed. Therefore, a continuous fraud
detection mechanism should be in place, because management may be unaware about the
failure of prevention mechanism.
Section 5.2 describes three financial statements. Section 5.3 identifies the fifty two financial
ratios / variables for detection of financial statement fraud. Ten financial variables have been
identified on the basis of behavioural characteristics for prevention of fraudulent financial
reporting in Section 5.4. The variables identified in this chapter will work as input vector to
the proposed data mining framework in order to accomplish the goal of prevention at the first
place and detection of financial statement fraud in case of failure of preventive measures.

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