Professor Arthur Dignam
Case 1.8 Crazy Eddie, Inc.
1) Some key ratios to consider in the effort to evaluate Crazy Eddie, Inc.’s audit risk are the current ratio, inventory turnover, and net profit margin. The current ratio gives a good indication of the company’s liquidity, which in turn reflects the company’s ability to pay short term liabilities as they come due. Through the four years spanning 1984 to 1987, Eddie’s current ratio saw an upwards trend; .93 for ‘84, 1.56 the next year, a slight decrease to 1.40 the year after that, and finally a jump to 2.41 in ’87. What does this mean? Well, Eddie’s current ratio was never very high—in fact, it was below 1 in the first year we’re given, which is a bad sign. The fact that the ratio improved would indicate that the company was steadily growing financially stronger. The next ratio up for consideration is inventory turnover. Since misrepresentation of inventory was such a crucial part of the fraud, we would do well to pay particular attention to this ratio, which essentially tells the analyst how frequently during the year the inventory cycle completes itself. To further elaborate, inventory turnover is a measure of the company’s ability to convert inventory into sales. During the given fiscal years, inventory turnover can be observed to be decreasing. The ratio starts, at the end of ’84, at 5.881. In following years, it is 5.13, then 4.38, and finally 3.23 in ’87. A low inventory turnover is indicative of a couple of possibilities; the first being that the company is simply inefficient, and has a weak sales department. Alternately, or perhaps at the same time, it can indicate that there is surplus inventory, or that production is too high. We should be careful not to assume, however, that higher inventory turnover always reflects a better position for the company. A high inventory turnover, along with possibly indicating strong sales, can also signal shortages, which leads to...