Numbers Don’t Lie
Financial Ratios Can Help Detect and Deter Fraud
by Andrew Shea & Scott O'Connell
Universal Advisor, 2008 Issue No. 2

The typical business loses 5 percent of its annual revenues to fraud — 5 percent! While most businesses like to believe they’re atypical, and thus impenetrable, we’re here to provide an unwelcome reality check: not only could fraud happen at your organization, it could be happening right now.

What can organizations do to identify fraud early on? Financial statement ratios are one way to detect and guard against fraud in a cost-effective manner. 

By the Numbers

Using financial statement ratios is an effective way to uncover — early on — possible areas where fraud may be occurring in an organization. We’re not talking about the typical financial ratios that accounting and finance personnel frequently rely on, such as a quick ratio or a debt-to-equity ratio. Perpetrators of fraud can circumvent these analyses with relative ease. Instead, consider computing the following ratios to identify fraud indicators before they take a toll on your bottom line. Please note the following formulas assume a year-end assessment but can be modified for daily, weekly, or monthly results. 

Days in Sales Receivables Index (DSRI)

How to Calculate: Current period accounts receivable over current period sales divided by prior period accounts receivable over prior period sales.

What It Indicates: DSRI measures whether receivables and revenues are consistent over consecutive reporting periods. If there’s unusual growth in the DSRI, it could be an indicator that accounts receivable are overstated or not collectible. In applying this ratio, it’s important to develop a baseline to which you can compare future results, as a certain ratio could be appropriate in one industry but a red flag in another.  

Sales Growth Index

How to Calculate: Divide current year sales by prior year sales.

What It Indicates: Significant unexplained increases could be a red flag that staff are inflating sales or creating fictitious sales (perhaps to increase commissions or target bonuses). Significant unexplained decreases could indicate that staff members are diverting sales to another company.  

Inventory Turnover

How to Calculate: Divide the cost of goods sold by average inventory for the time period you want to measure.

What It Indicates: Inventory turnover determines how often inventory is sold or replaced during a given time period. A decreasing ratio reflects an increase in inventory relative to cost of goods sold. This may be an indication that staff aren’t properly expensing or writing off inventory. An increasing ratio may be a sign that there’s significant inventory shrink. 

Employee Increase to Sales Increase

How to Calculate: Divide the change in the number of employees by the change in sales dollars over a specific time frame.

What It Indicates: This ratio can be indicative of fictitious or diverted sales. If there’s a large increase in sales dollars and a minimal increase or decrease in employees, this may be a red flag that sales are overstated. Conversely, if there’s a large increase in staff, coupled with a slight increase or decrease in sales, it could suggest off-the-book sales are occurring.  

Number of Vendors Compared to Cost of Goods Sold

How to Calculate: Divide the number of vendors by the cost of goods sold.

What It Indicates: Oftentimes, if cost of goods sold as a dollar amount is going up, the number of vendors would not substantially decrease. If those two items are simultaneously increasing and/or decreasing, it could be a red flag that suggests kickbacks from vendors, non-competitive bid processes, or an employee setting up a side business and using it as a preferred vendor.  

Numbers Don’t Lie

Calculating targeted ratios is an important step in identifying potential fraud in the workplace. Using these types of calculations won’t eliminate the possibility of fraud altogether, but it will help you gauge early on if there are issues that need further investigation. For more information regarding these ratios or additional ratios that may be helpful for your particular circumstance, give us a call.