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On May 24, "The Boston Globe" reported that Kurzweil Applied Intelligence, Inc. had fired its Vice President of Operations. In addition, the President/Chief Financial Officer, Vice President of Sales, and Vice President/Treasurer all resigned. These changes followed an auditors' finding that several "significant transactions" on the company's books "do not appear to have been bona fide transactions." Kurzweil's stock dropped nearly 61% on the news.
Supposed you had been offered a job at Kurzweil on May 20? Would you have been able to predict the company's problems?
"Let the Buyer Beware" has no greater relevance than senior executives' considering employment offers with new companies. In a previous column, we spoke about the Scuttlebutt Technique as a way of evaluating an organization's reputation within a particular marketplace. The focus of this column will be on simple ways to look identify companies that might be prone to engage in financial shenanigans.
Shenanigans are actions taken to hide or to distort the real financial condition of a firm. These actions may include legal but minor deceptions to outright fraud.
Howard Schilit has identified some warning signs for the company prone to engage in shenanigans. Schilit is President of the Center for Financial Research and Analysis in Rockville, Maryland. www.cfraonline.com
It is important to remember that these warning signs don't necessarily indicate that shenanigans are taking place. A number of such warning signs indicate fertile soil for such actions.
One technique which can be used is to analyze the Quality of Earnings. This ratio is developed by dividing cash flow from operations (CFFO) by reported net income. If a target company has a high net income relative to other companies its size in its industry, then there should also be a high Quality of Earnings ratio. A high ratio under these conditions suggests that the net income was truly earned in the course of business. If, on the other hand, CFFO is negative while net income is positive you might have reason to worry.
The CFFO/net income comparison is particularly pertinent for companies whose sales, receivables, and inventory don't fluctuate rapidly from year to year. Fast growth companies might well have CFFO/net income ratios of less than 1.0 and still be shenanigan-free.
How can you compare a target company's earnings with that of competitors? One source of information might be to look at industry statistics collected by Robert Morris Associates. This data may be obtained if you know a loan officer at a commercial bank. They usually have Robert Morris Associates surveys as a reference tool for evaluating loan applications. Keep in mind that Robert Morris Associates surveys are NOT representative of all companies. They are tabulations of all companies which have applied for commercial loans. While not ideal, Robert Morris Associates is at least a start.
The vast majority of private and public companies in Boston conduct their businesses in an ethical and honest fashion. The few who do engage in shenanigans may win in the short term. In the long run, these companies damage the reputation of the free market system and can do irreparable harm to innocent employees.
Do your homework in advance so that you don't get involved.
Dr. Laurence J. Stybel and Maryanne Peabody are co-founders of Stybel Peabody Lincolnshire, a senior executive level career consulting firm based in Boston and twenty five other cities in three countries. They were voted "Best Outplacement Firm" by the readers of Massachusetts Lawyers Weekly. Maryanne and Larry can be reached at 781/736-0900.