This memorandum is conducted on behalf of Cariboo Industrial (CI) Ltd to detect areas that are most prone to accounting fraud as well as recommend solutions to restructure the business in the short and medium-long term. CI was a retail chain specializing in the sale of industrial equipment and supplies to commercial contractors in British Columbia and Alberta. The company owner – Ms. Martha McMaster – was running the business successfully until 2001. In early 2001, Jack Venables was hired to manage the company since Ms. Mc Master suffered a debilitating stroke. Jack Venables took advantage of his position to commit business fraud and ran away with his girlfriend who is also the auditor of the company. CI was in a strong financial position in 2000 and 2001, ROA of 17. 4%, profit margin of 28. 4%, average current ratio of 1. 7, and the average debt ratio of 40%. Given these ratios, CI was considered in good short-term liquidity, moderate capital structure leverage, and profitable business. However, under Jack Venables’s management, the outlook of the company becomes gloomy.
Regarding its operation, account payable – the amount that the company owed its suppliers – was stretched to the point that many suppliers had cut the company off from any further credit. Account payable was stable at US$1,594 million during 2000 and 2001 which was around 7% of total assets. Days of account payable outstanding were around 44 days. However, account payable increased by 12 times to US$18,880 million in 2003. Short term liquidity and profitability were also in trouble. During 2002 and 2003, the average current ratio dropped to 0.32, ROA of 6. 15%, and a profit margin of 16. 2%. Moreover, the Calgary Bank (CB) had called CI’s line of credit and long-term loans due to the current ratio lower than 1. 5. It is significantly concerned about the company’s long-term solvency position since the debt ratio was an average of 65% during 2002 and 2003. Furthermore, Jack Venables overpaid for the land property – a waste of huge amount of company’s cash – and gave himself unauthorized raises and bonuses and spent lavishly on entertainment and business travel.
He even made sales to fictitious companies owned by his family members which led to a 6 times increase in account receivable between 2000 and 2003. This account receivable was only expected to collect not more than US$ 5million – equivalent to 0. 035% of the total amount outstanding. The majority of customers had taken their business elsewhere since inventory in most of the company’s retail outlets had fallen to the lowest levels. In terms of cash flow, the company is significantly in short of cash position which is far below the amount needed to support capital expenditure and dividend payment. The main source of cash is from financing activities which even exaggerate the company’s riskiness. The cash infusion of $3,913,000 in November 2003 is seemed insufficient. The company need to raise more cash to pay the supplier immediately in order to top up inventories and continue its business. Moreover, the company needs to focus on marketing activities and customer services to attract back customers. Finally, an internal audit system should be established in the long-run to prevent and detect fraud. CI’s cash position is very weak. Cash dropped from 0.
7% of the total assets in 2000 to 0. 2% of total assets in 2003. CI’s cash position will be analyzed in detail in the cash flow statement analysis. Account receivable increased by 471% from US$ 2,490 million in 2000 to US$ 14,216 in 2003. This is due to Venables’ s fraud action of selling company products to freak companies owned by his family members. All inventories that were shipped to the warehouse of these companies were disappeared. It is estimated that CI can only collect at most US$ 5 million – equivalent to 0. 035% of total account receivable outstanding. Therefore, the company should write off the account receivable to reflect the true total current asset position. Days of accounts receivable outstanding jump from 55 days in 2001 to 88 days in 2003Inventories increased by only 9% from 2000 to 2003. Too low levels of inventory led to the problem of losing customers. Moreover, on liquidity events, these inventories are estimated to yield only 50% of their book value. Account payable was sharply increasing from 2000 to 2003. Account payable was US$1,594 million in 2000 which accounted for around 7% of total assets and increased by 12 times to US$18,880 in 2003.
The account payable outstanding is up to the limit that suppliers had cut the company off from any further credit. This may explain why the company cannot top-up its inventory since it is in a huge shortage of cash and no longer has credit offered by suppliers. The company’s cash conversion cycle became negative in 2003 which is the result of too much account payable outstanding. Low cash conversion cycle is normally a good since the company does not tie up too much their money in working capital, but in this case too low and even negative cash conversion cycle led to big troubles with suppliers.