Negative ones 1. Small firm with explosive growth – growth will slow down 2. CEO is a marketing guy, maybe poor at cost control
Positive ones 1. It is now audited Peat Marwick, the Big-8 firm!! Woow 2. CEO: we diversify our product lines 3. Value Line (a prestigious stock/mutual fund research company: project that in FY 1989, Kando’s profit will increase by another 30% 4. Barron’s and BW: favorable reviews 5. Even Warren Buffet is said to be interested
*If you get this audit client, you will be rich!!

| 1988 | 1987 | 1986 | Part 1 Profitability ratios | | | | Gross margin (%) | 48 | 45 | | Operating income ratio (%) | 12 | 11 | | | | | | Part 2 Liquidity ratios | | | | Current ratio | 4.08 | 2.05 | | Quick ratio | 2.38 | 1.24 | | Cash ratio (cash/current liability) | 3.80% | 2.10% | | | | | | Note: both profitability and liquidity are improving. It confirms our success story!! | | | | | D/E ratio (total liab./equity) | 2.79 | 2.25 | | T.Liab./T.Assets | 0.74 | 0.68 | | Interest expense coverage (EBIT/interest expense) | 6.87 | 9.39 | | | | | | Whirlpool | | | | D/E ratio | 3.34 | 2.58 | 3.16 | T.Liab./T.Assets | 0.77 | 0.72 | 0.76 | Interest expense coverage | 1.81 | 4.02 | 4.06 | | | | | Note:The leverage ratio is a bit too high, but still okay, since the interest coverage ratio is still good | Leverage ratio is normal compared with competitor (Whirlpool) | Operating income is high enough to cover interest expense | | | | | | Part 3 Trend analysis | | | | Revenue | 41% | 68% | | Net income | 54% | 74% | | SG&A Exp. | 50% | 41% | | Inventory | 100% | 93% | | Total assets | 81% | no info | | A//P | -12% | no info | | (Cash discount might drive it) | | | | | | | | Overall, revenue grows, profit increases, total assets rise! | | If we take on this kind of high-growth client, our firm will be see steady audit fee increase of 40% every year!!! | | | | | High quality analytical review/procedures | | | Part 4 Turnover ratios | | | | 1) A/R collection days (= A/R-gross*365/sales) | 104 | 80 | 2) Inventory turnover days (inv.*365/COGS) | 150 | 101 | 3) A/P payment days (A/P*365/COGS) (cut credit? Or speedy payment?) | 51 | 78 | 4) Working capital cycle (1 + 2 - 3) | 204 | 103 |
Note: the writing is on the wall, when all numbers are put together!!! The firm needs to put more and more cash into the working capital investment. | | | | | Further Evidence on the Forthcoming Demise | | | Trend analysis | | | | 1) Sales growth (%) | 41 | 68 | | 2) A/R growth (%) (= 51,076/27,801 - 1) | 84 | 93 | | 3) Inventory growth (%) (= 39,135/19,577 - 1) | 100 | 100 | | 4) A/P change (%) (= 13,288/15,072 - 1) | -12 | 105 | | 5) Bank debt growth rate (%) | 698% | NA | | 6) Change in AFDA (%) (426/476/200) | -11 | 138 | | Why the firm needs to borrow so much money (41.5m increase)? | | | | | Flag 1: AFDA | | | | 1) as % of sales | 0.80% | 1.68% | | 2) as & of gross A/R balance | 0.23% | 0.37% | | Note: whichever rate you use, you smell intentional fraudulent manipulation by the management. | | | | | Flagg 2: Inventory stay-in days increased by 50% (101 days