AUDIT ANALYTICS AUDIT

AUDIT ANALYTICS AND CONTINUOUS AUDIT:LOOKING TOWARD THE FUTURE
Example 2: Financial Ratio Peer Analysis 3
An important indicator of financial health or lack thereof and thus of
interest to an auditor trying to understand the entity and assess risk is
how the entity’s key financial ratios compare with those of its industry
peers. In this example, we show frequency distributions of several key
ratios for the wholesale and retail sector (SIC codes 5000 to 5999) against
which the ratios of any audit client in that sector can be compared. If a
particular ratio is located in the tail end of the distribution it indicates a
deviation from the industry norm, which may be good or bad depending
on the ratio, which tail, and how far out. A visualization of the complete
distribution allows the auditor to make a judgment based on a complete
picture of the sector; the client ratios can all be viewed juxtaposed against
the relevant distributions and viewed together dashboard-style; and the
ratios and their relative positions tracked year to year for signs of
improvement or deterioration.
The Compustat database, which includes approximately 430 companies
in the SIC 5000-5999 sector, was used to develop the distributions from
2013 data. For example, figure 5-6 shows the distribution of the current
ratio (current assets divided by current liabilities). It can be seen that the
distribution is very highly skewed. Just looking at the distribution it
would seem that current ratios between 1 and 3 are the norm, ratios less
than 1 are potentially worrisome, and a very high ratio (the highest in the
database is nearly 16) might indicate a potential problem with the data,
possibly a misclassification of current assets or current liabilities.
While it is helpful to visualize the shape of the distribution, cumulative
frequency distributions are generally more useful because percentiles can
be read directly. Cumulative frequency distributions for several ratios
derived from the Compustat database are displayed in figure 5-7. The
first chart is the cumulative distribution for the current ratio and
corresponds to the frequency distribution in figure 5-6. Additional ratios
presented include inventory turnover, return on assets (ROA), and
long-term debt to equity. A table of statistics is included to the right of
each chart. It can be seen from the cumulative distribution, for example,
that the median current ratio, the 50th percentile, is approximately 1.7.
It’s the point on the horizontal axis corresponding to 50 percent on the
vertical axis. The table gives it more accurately as 1.657. It can be seen
that only 5 percent of this peer group have current ratios of 0.740 or less,
so the auditor who considers a low ratio to be a risk might have concerns
if the entity’s ratio is that low.
3 I thank Paul E. Byrnes of Rutgers Business School for providing me with an unpublished paper
on which the examples and data in this section are based.
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