FT11105_Aditya Goel_FSAV_assignment

Aditya Goel FT11105FSAV Take Home Test

1. Using information in financial statements as originally reported in Exhibits 5.27 to 5.29; compute the value of Beneish’s manipulation index for fiscal year 5 and 6.

Answer:

Beneish developed a statistical model to identify the financial characteristics of companies which are likely to engage in earnings manipulation. The Beneish model used here uses 8 factors to measure the likelihood of the firm manipulating its financial statements. Using these 8 factors Beneish manipulation score is calculated. Using the manipulation score, we calculate the probability of manipulation using the NORMSDIST function of excel.

For Millennial technologies, Beneish score for year 5 is -0.21 and probability of manipulation is 41.5%. Therefore with a high level of confidence we can say that Beneish might have worked its financial statements.

For year 6, the Beneish score is 0.94 and probability of manipulation is 82.52% indicating that there is a high risk that Millennial could have indulged in earnings manipulation.

S.No

Index Formula Year 5 Year 6

Index value

Index value

1 Days sales in receivables

index

ratio of accounts receivable to sales for current year/ratio of

accouns receivable to sales for previous year

1.56 1.04

2 Gross margin index

Gross margin as a percentage of sales last year/gross margin as a percentage of sales for current

year

1 1.2

3 Asset quality index

proportion of lower quality assets during current

year/proportion of lower quality assets during the preceding year

0.99 0.09

4 Sales growth index

sales of current year / sales of previous year

1.52 3.04

5 Depreciation index

ratio of depreciation expense to PPE for previous year/ratio of

depreciation expense to PPE for current year

1.1 1.68

6 Selling and Administrativ

e expense index

ratio of SGA to sales for current year/ratio of SGA to sales for

previous year

1.18 0.45

7 Leverage index

proportion of total financing comprising currnet liabilities and

long-term debt for the current year relative to the proportion

for the preceding year

2.12 0.54


8 Total accruals to total assets

Accruals (net income - operating cash flow) as a percentage of total assets for current year

0.36 0.32

9 Beneish's manipulation y value -0.21 0.94

10 Probability of Manipulation 41.50% 82.52%

2. Using information from Beneish’s manipulation index and financial ratios in Exhibit 5.30, indicate possible signals that millennial technologies might have been manipulating its financial results.

Beneish index helps to identify the financial characteristics of companies which are likely to engage in earnings manipulation. For Millennial technologies, the Beneish index predicts a 41% probability of earnings manipulation in year 5 and 82% probability of manipulation in year 6. This is a very strong signal that there could be some earnings manipulation which needs to be probed further.

Apart from the Beneish index, the below mentioned issues raise doubts about the accuracy of the financial statements: A significant increase in accounts receivable as a percentage of sales in

both year 5 and year 6 indicate that there might be some fictious sales or some relaxation of credit terms to push sales.

A significant portion of the assets are classified as “other assets”. This indicates that the quality of the assets is not that high. Other assets usually include categories like Good will or capitalized costs. Since the future benefits of these assets is less certain, a higher proportion of “other assets” will raise some doubts.

Accounts receivable and inventories make up 60% to 70% of the total assets, which is very abnormal. This means that the company is having lots of uncollectible accounts or outdated inventory and is not writing them off properly.

Accounts receivable turnover has decreased from 6.9 in year 4 to 4.6 in year 6. This means that company is taking more time to convert its receivables to cash. This would mean that some of its account receivables are fictious or bad debts have increased.

Selling and general administrative expenses as a percentage of sales has decreased from 27% in year 5 to 12.1% in year 6. This drastic reduction will raise doubts whether expenses are being capitalized.

Operating cashflows are negative for all the years. Also, there has been a steady increase in the gap between accrual based profit and operating cashflows. This should indicate that the firm could be resorting to some manipulation of accrual profit.

Days account payable has halved from 63 in year 5 to 39 in year 6. This might indicate that suppliers are demanding their money to be paid faster because they might have an indication of the problems with the company.


Or, management has included certain other items in accounts payable, which have not been disclosed.

The long term debt ratio of the company is very low at 0.8%. Sales are growing at a rate of 230%. This means the company will need lot of funding, but most of funding is through equity even though equity is costly compared to debt. This might mean that the company is not confident of paying interest on debt on a regular basis (probably because it knows the status of its operations) and is therefore preferring equity.

The firm is growing very rapidly at around 230% and will therefore need lot of funds. However, its long term debt to equity ratio is less than 1% where as its short term notes payable is pretty high. This indicates that the firm is financing most of its debt through short term borrowing. This might be because there is no long term borrower willing to lend since they are not convinced about the firms sustainability.

3. Describe the effect of each of the eight accounting irregularities on balance sheet, income statement and statement of cashflows.

Answer:

The effects of the accounting irregularities are discussed

I. Recording of invalid sales transactions Effect on balance sheet:

o Higher assets because of increase in accounts receivableo Higher share holder equity due to increased retained earnings

(retained earnings increase due to higher profit reported) Effect on income statement:

o Higher revenues Effect on cash-flow statement:

o No changeII. Recording of revenues from bill and hold transactions

Effect on balance sheet:a. Higher assets due to increase in accounts receivableb. Lower inventories because inventories are converted as salesc. Higher share holder equity due to increased retained earnings


a. Higher revenues for the current period at the expense of next period

Effect on cash-flow statement:a. No change

III. Manipulating inventory balances by including dummy boxes Effect on balance sheet:

a. Higher assets due to increase in inventory Effect on income statement:

a. Higher profits because of lower cost of goods sold. Effect on cash-flow statement:

a. No change


IV. Failure to write down inventory for product obsolescence Effect on balance sheet:

a. Higher than actual assets due to increase in inventoryb. Higher share holder equity due to increased retained earnings


a. Higher profits because the losses in inventory are not accounted for


V. Capitalization of costs Effect on balance sheet:

a. Higher assetsb. Higher share holder equity due to increased retained earnings


a. Higher profits because some of the costs are not included Effect on cash-flow statement:

a. No change

VI. Manipulation of prepaid licenses as advances Effect on balance sheet:

a. Change in composition of assets – the “prepaid asset” account is undervalued where as “notes receivable” account is overvalued.

Effect on income statement:a. Higher profits because of lower amortization costs


VII. Failure to provide adequately for uncollectible amounts in accounts receivable Effect on balance sheet:

a. Higher assets due to overvalued accounts receivable account Effect on income statement:

a. Higher revenues because lower Effect on cash-flow statement:

a. No change

VIII. Failure to write-down investments even after the investments have lost significant value Effect on balance sheet:

a. Higher assets shown on balance sheets Effect on income statement:

a. Higher profits because losses on investments are not booked Effect on cash-flow statement:

a. No change


4. Using information in the restated financial statements in Exhibits 5.31 to 5.33, the financial ratios is Exhibit 5.34, and the information provided in the case, would you as a commercial banker be willing to offer millennial technologies a line of credit as of July 31, year 7? State the conditions that would induce you to offer such a line of credit?

Answer:

A number of factors need to be considered before a lending decision is made. Most important of these are the liquidity and solvency figures of the firm. Some of the important liquidity and solvency ratios for Millennial technologies are given below:

Ratio Year 7

Year 6

Year 5

Year 4

Liquidity ratiosCurrent ratio = 1.20 4.18 1.61 5.27quick ratio= 0.25 2.53 0.74 2.55Operating cash flow to current liabilities ratio =

-0.56 -3.15 -2.20 -1.23

Accounts receivable turnover =

3.36 4.75 4.40 7.76

Days receivables outstanding =

108.68

76.81 82.94 47.02

Inventory turnover =

3.13 5.71 6.15 3.39

Days inventory held =

116.46

63.92 59.31 107.63

Solvency ratiosLong term debt ratio =

0.00 0.01 0.04 0.00

Debt to equity ratio =

0.00 0.01 0.04 0.00

Liabilities to assets ratio =

0.44 0.22 0.55 0.17

Interest coverage ratio =

-108.1

1

-10.57 -78.08 -2.03

Interest coverage ratio based on cashflows =

-21.50 -58.45 -88.14 -3.51

Operating cashflows to total liabilities ratio =

-0.55 -3.03 -2.14 -1.23

Let us look at each factor affecting the lending decision one by one.


Circumstances leading to the need for loan: Millennial technologies needs cash to finance its working capital needs. The line of credit will be used to finance accounts receivable and inventories. However, the firm has significant operational problems. It is not able to move its inventories or collect cash promptly. Therefore there is significant credit risk involved.

Cashflows:

The firm has significant negative cashflows from operations. Also, the firm has been unable to monetize its inventories or collect cash

promptly from customers. Accounts receivable and inventories turnover ratios are pretty high and have been increasing from year to year as shown above.

Operating cashflows to total liabilities and operating cashflows to current liabilities is still negative but has improved in year 7.

Collateral: Most of the firm’s assets are made up of accounts receivable and inventories. There are no marketable securities as of year 7. Given the firms problems with collection of receivables the value of the receivables on book might be overstated and difficult to liquidate if need be. Also, the firm is a fast changing industry and its inventory could turn obsolete very soon. Therefore, there is considerable risk involved in liquidating the collateral.

Capacity for debt: The firm’s long term debt to equity ratio looks good because there is no long term debt. This is because the firm is in distress and no one is willing to lend. Having said that, the firm’s debt to equity ratio is 44% indicating that there is some scope for raising long term debt if the firms operations improve in the future.

Contingencies: The firm faces huge contingency risk from unresolved class action law suits and other penalties that might be imposed by regulators.

Character of management and corporate governance structures: Recent events show that the management is not trustworthy and the firm lacks adequate control structures.

Considering these adverse factors, I would be very sceptical about providing a line of credit to Millennial technologies. The firm has been unable to generate cash from its operations and has been sustaining itself on cash raised from share holders in Year 6. If I were to lend, I would insists on

Significant restructuring of operations. Debt covenants which keep a tight leash on cash available, receivable and

inventory turnovers. Higher collateral and interest margins New equity infusion into the company.

5. Compute Altman z-score for fiscal year ending on March 31, Year 7.


Answer:

Altman Z score can be used to predict the likelihood of bankruptcy for the firm under consideration. It uses five factors to calculate the Z score. Z scores below 1.81 indicate a high probability of bankruptcy, while Z-scores above 3 indicate a low probability of bankruptcy. Scores between 1.81 and 3 are in the gray area.

The Z-score for Millennial technologies as on 31st March, Year 7 is -2.26. This indicates that the probability of bankruptcy is very high.

S.No

Factor Value of the factor as on March 31st,

Year 7

Weight of the factor

1 (Net working capital / total assets) 0.089241767 1.22 Retained earnings/total assets -1.047501856 1.43 EBIT/total assets -0.840911754 3.34 Market value of equity/Liabilities 2.21111853 0.65 Sales/Total assets 0.552033283 1

Altman Z score -2.255716866

6. Can millennial technologies avoid bankruptcy as of mid year 7? Why did not Altman model signal the financial difficulties earlier than they do?

Answer:

The chances of Millennial technologies avoiding bankruptcy as on mid year 7 is very low. The firm is unable to generate cash from operations. Also, it does not have quality assets to put as collateral and raise loans. Because of the fraud committed, it would not be able raise fresh equity. So, it is difficult for the firm to avoid bankruptcy.

Altman Z-score was not very effective in predicting bankruptcy early on because Altman score uses accrual basis income statements and balance sheet

data instead of cash-flow data. But accrual based statements are more easily subject to manipulation compared to cash flow statements. In millennial technologies case, Altman score was using many accrual based ratios, but all these ratios were manipulated to present a rosy picture of the firm. Had the model included some cash-flow based ratios, it could have predicted the possibility of bankruptcy earlier (because the cash-flow are more difficult to manipulate).

Also, market value of equity is a critical factor in calculating Altman Z score. Since the equity valuations were very high (because of manipulated financial statements), the Z score was high and could not predict the possibility of bankruptcy.


Documents

FT11105_Aditya Goel_FSAV_assignment