What are the pros and cons of using the strategic audit as a framework for case analysis? Choose one section of the case analysis discussed in Chapter 12 and apply this to Wal-Mart. Please use the case analysis below to apply to Wal-Mart.
Identifying Red Flags:
Howard Schilit, founder of the Center for Financial Research & Analysis (CFRA), works with a staff of 15 analysts to screen financial databases and analyze public financial filings of 3600 companies, looking for inconsistencies and aggressive accounting methods. Schilit calls this search for hidden weaknesses in a company’s performance forensic accounting. He advises anyone interested in analyzing a company to look deeply into its financial statements. For example, when the CFRA noticed that Kraft Foods made $122 million in acquisitions in 2002, but claimed $539 million as “goodwill” assets related to the purchases, it concluded that Kraft was padding its earnings with one-time gains. According to Schilit, unusually high goodwill gains related to recent acquisitions is a red flag that suggests an underlying problem.
Schilit proposes a short checklist of items to examine for red flags:
Cash flow from operations should exceed net income: If cash flow from operations drops below net income, it could mean that the company is propping up its earnings by selling assets, borrowing cash, or shuffling numbers. Says Schilit, “You could have spotted the problems at Enron by just doing this.”
Accounts receivable should not grow faster than sales: A firm facing slowing sales can make itself look better by inflating accounts receivable with expected future sales and by making sales to customers who are not creditworthy. “It’s like mailing a contract to a dead person and then counting it as a sale,” says Schilit.
Gross margins should not fluctuate over time: A change of more than 2% in either direction from year to year is worth a closer look. It could mean that the company is using other revenue, such as sales of assets or write-offs to boost profits. Sunbeam reported an increase of 10% in gross margins just before it was investigated by the SEC.
Examine carefully information about top management and the board: When Schilit learned that the chairman of Checkers Restaurants had put his two young sons on the board, he warned investors of nepotism. Two years later, Checkers’ huge debt caused its stock to fall 85% and all three family members were forced out of the company.
Footnotes are important: When companies change their accounting assumptions to make the statements more attractive, they often bury their rationale in the footnotes.
Schilit makes his living analyzing companies and selling his reports to investors. Annual reports and financial statements provide a lot of information about a company’s health, but it’s hard to find problem areas when management is massaging the numbers to make the company appear more attractive than it is. That’s why Michelle Leder created her Web site, www.footnoted.org. She likes to highlight “the things that companies bury in their routine SEC filings.” This type of in-depth, investigative analysis is a key part of analyzing strategy cases. This chapter provides various analytical techniques and suggestions for conducting this kind of case analysis.
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