Financial Ratios: The Secret Weapon in Securities Fraud Litigation
J.W. Verret
Financial Ratios: The Secret Weapon in Securities Fraud Litigation
J.W. Verret, JD, CPA/CFF, CVA, CCFI
In the high-stakes world of securities litigation, the numbers tell the story if you know how to read them. Using publicly available numbers to tell a story about a defendant in a securities fraud suit has become even more important since Congress and courts have limited early discovery. Congress enacted the Private Securities Litigation Reform Act (PSLRA) in 1995, since that time securities fraud plaintiffs have faced a formidable challenge: pleading fraud "with particularity" and establishing a "strong inference" of fraudulent intent without the benefit of discovery.
Many plaintiffs have worked to meet this hurdle using confidential whistleblowers whose informed perspective can buttress the complaint. This article explores how forensic accounting and ratio analysis can also come into play at this early stage of litigation, transforming dry financial statements into powerful evidence for both plaintiffs and defendants to defend their positions during the earliest stages of this litigation.
The PSLRA Obstacle Course
The PSLRA created significant hurdles for plaintiffs:
Pleading falsity with particularity: Plaintiffs must specify which statements were false and exactly why they were false—general allegations of "GAAP violations" aren't enough.
Strong inference of scienter: Perhaps the highest bar, plaintiffs must plead facts that create an inference of fraudulent intent that is "cogent and at least as compelling as any opposing inference of nonfraudulent intent," as the Supreme Court clarified in Tellabs.
Automatic discovery stay: While defendants can freely access internal documents, plaintiffs are prevented from obtaining discovery until after surviving a motion to dismiss.
Plaintiffs must find evidence of fraud in public filings—which is exactly where forensic accounting shines.
Reading Between the Numbers: How Ratios Reveal Fraud
Financial ratios serve as a sort of corporate lie detector test. When executives manipulate financial statements, these manipulations leave fingerprints in the relationships between different accounts. Analysts can connect the dots between information across the financial statements, contained within the footnotes to the financial statements, and presented in transcripts of company earnings calls that demonstrate unexpected relationships that require explanation by the company.
Financial ratios can help to meet PLSRA particularity requirements on their own, or can work in conjunction with confidential witnesses to corroborate the red flags raised by confidential witnesses.
Some key ratio categories include:
Revenue Recognition Red Flags
Revenue fraud often involves recognizing sales too early or booking fictitious revenue. These tricks manifest in several key ratios:
Accounts Receivable Growth vs. Sales Growth: When receivables grow much faster than sales, it may signal premature revenue recognition or "channel stuffing" (pushing excess inventory to distributors). A plaintiff might plead: "Receivables grew at triple the rate of sales, suggesting defendants were recording revenue far faster than they could collect cash."
Days Sales Outstanding (DSO): This ratio shows how long it takes to collect payment after a sale. A sharp increase often indicates quality problems with recorded revenue. For example: "DSO ballooned from 45 to 75 days during the class period, a warning sign that sales were being booked without legitimate customer demand."
Increase in Sales Returns/Total Sales Ratio: This may indicate a lack of real demand for products being stuffed into the sales channel.
Expense and Liability Manipulation Metrics
Companies may also manipulate expenses through aggressive capitalization or extended depreciation:
Asset Quality Index (AQI): This measures the proportion of assets other than property and equipment. Rising AQI often indicates companies are capitalizing what should be expenses. Plaintiffs could argue: "The company's 'deferred project costs' assets ballooned by 300%, suggesting normal operating expenses were being improperly parked on the balance sheet."
Depreciation Index (DEPI): When companies stretch asset lives to reduce expenses, this shows up as declining depreciation rates. This provides another concrete allegation: "Depreciation expense as a percentage of assets dropped by half with no disclosure of methodology changes—a deliberate accounting choice to boost short-term earnings."
Total Accruals to Total Assets (TATA): High accruals relative to assets indicate earnings created by accounting entries rather than cash-generating operations. The Beneish M-Score model, developed by Professor Messod Beneish, uses this and other ratios to detect earnings manipulation.
Flipping the Script: How Defense Counsel Responds
Defense attorneys can effectively counter ratio-based allegations using the same analytical toolkit:
Alternative Explanations: The PSLRA's "strong inference" standard requires showing fraud is at least as likely as innocent explanations. For example, if receivables spike, defense might argue: "The company secured new large, credit-worthy customers who negotiated longer payment terms, fully disclosed in the 10-K's footnote 7."
Industry Benchmarking: Context matters. If everyone in the industry experienced similar ratio changes, the inference of fraud weakens. Defense counsel might show: "All semiconductor manufacturers saw extended DSO during the supply chain disruption, as noted in analyst reports."
Time-Series Analysis: Plaintiffs often cherry-pick quarters. Showing that ratios returned to normal in subsequent periods, or followed a predictable seasonal pattern, counters scienter allegations.
Challenging Materiality: Even if unusual patterns existed, a company can argue they were immaterial to investors (price impact) or already understood by the market and thus a part of the total information already available in the market.
Practical Advice for Litigators
For Plaintiffs' Counsel
Comparative context: Show how the company's ratios diverged from its own history, industry peers, or economic conditions.
Connect the dots: Explicitly link ratio anomalies to the alleged fraud scheme and scienter. Explain why management must have known about the red flags.
Corroboration: Where possible, pair ratio analysis with other evidence—confidential witnesses, analyst questions, subsequent restatements—to strengthen the inference of fraud.
Mind the materiality: Choose ratios that meet the materiality definition in the securities laws.
For Defense Counsel
Verify the math: Did the plaintiffs miscalculate ratios or use inconsistent time periods?
Present the full picture: Show all relevant ratios, not just the potentially cherry-picked ones, and place them in appropriate context.
Contemporaneous explanations: Highlight any disclosures, analyst call discussions, or industry news that explained the ratio changes at the time.
Cross-checks: Demonstrate that other related ratios remained normal, undercutting the inference of manipulation.
Expert support: Consider early retention of accounting experts to provide alternative explanations for ratio anomalies.
Conclusion
In the challenging world of securities litigation under the PSLRA, forensic accounting ratios serve as a powerful tool for both sides. For plaintiffs, they transform public filings into a roadmap of fraud that can clear the "strong inference" hurdle. For defendants, they provide context and alternative narratives that can defeat those same inferences.
As courts continue to demand particularized allegations of fraud, mastery of financial ratio analysis has become not just helpful but essential for securities litigators. The numbers don't lie, but they do tell different stories depending on who's interpreting them and how they're presented. The attorneys who best understand how to wield these financial tools gain a decisive advantage in the high-stakes battle of the motion to dismiss.