Imagine working at a company for a period of time, checking your bank account and realizing that no paycheck had been deposited in exchange for your work. This scenario would undoubtedly raise red flags. Similarly, cash flow analysis performed by lenders and auditors that reveals stagnant or negative cash flow can also serve as a warning sign that something is awry – and it could be fraud.
Cash flow is a significant indicator of a company’s overall health and operations. It allows investors, lenders and auditors to gauge the relative stability of a company by assessing its ability to avoid excessive borrowing, grow its business and endure hard times. Merger and acquisition professionals, business appraisers and lenders are keenly interested in the free cash flow of an organization. Auditors should be particularly aware of free cash flow and its ramifications, especially in designing an audit to look for fraud.
It is imperative to note how cash flow increases as sales increase, since both should be moving at a relatively consistent rate. This analysis can be conducted using a ratio of net operating cash flow to net sales, which shows how many dollars of cash are produced by each dollar of sales. Remember: the higher the percentage, the better.
|Net Income (loss)||(76,604)||(64,815)||4,385||52|
|Adjustments to reconcile net income (loss) to net cash from operating activities:|
|Depreciation of property & equipment||41,501||37,235||36,535||38,085|
|Loss on Sales of Equipment||10,895|
|Accounts receivable, net and other||164,231||(810,465)||376,837||(198,482)|
|Deferred Income Tax Benefit||202,360||(15,666)||48,710||10,620|
|(Decrease) Increase in:|
|Accrued expenses and other||(62,082)||33,047||(22,746)||(5,185)|
|Deferred Income Taxes Payable||(8,673)|
|Franchise Tax Payable||3,277|
|Deposits on Hand||(205,000)|
|Net cash provided by (used in) operating activities||172,495||(310,028)||(39,797)||(23,027)|
|Total Net Sales||1,106,112||1,156,410||1,299,210||1,946,820|
|Operating Cash to Sales Ratio||16%||-27%||-3%||-1%|
In the table above, the operating cash to sales ratio is low, and cash is decreasing despite sales increasing. Cash that is stagnant or decreasing when sales are increasing should set off alarm bells for anyone, especially an auditor. Fraud and cash go hand in hand. When there is a cash flow pattern such as this, it is probable that there may be fraud lurking under the surface.
Companies often have an asset-based revolving line of credit in which the company receives loan advances based on a set percentage of asset balances such as accounts receivable. The gross receivables are typically reduced by receivables 90 days and over to calculate the eligible receivables balance as the borrowing base. This balance is then multiplied by the agreed advance rate (usually between 75 and 85 percent) to arrive at the available loan advance amount.
A common fraud scheme related to this type of lending arrangement occurs when a company inflates accounts receivable to increase their borrowing capacity. While this can be executed in a variety of ways, the cash flow analysis shown above would reveal that something is amiss. For example, assume a company generates fake receivables to increase its borrowing base. After the fake receivable goes over 90 days old, the receivable is written off and the borrowing base is decreased – the company now must pay down its loan. Typically, to continue the fraud scheme, the company will then create a new receivable to replace the old fake receivable in order to maintain a level borrowing base. Once the company finds that this scheme works, it will then create more false receivables and begin a cycle which generates cash flow through fraudulent bank loans. Thus, a negative or lower cash balance will exist because receivables should have generated cash, but did not.
Auditors should always follow the cash when evaluating a company. External auditors are required to plan an audit to detect fraud. Internal auditors and regulators should also include this procedure cash flow analysis in their audits as a “best practice.” Cash decreasing despite an increase in sales could be an indication that fraudulent activity is occurring – and prudent auditors will find this procedure invaluable on their path to determine the source of the cash flow problem.