For each type of ratio/analytical tool, decide if there was adequate forewarning of Enron's demise. Thoroughly reading

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Question:

For each type of ratio/analytical tool, decide if there was adequate forewarning of Enron's demise.

Thoroughly reading about Enron and the mismanagement of their earnings record made me realize how obvious it was in some cases to see that their was financial stress within the company. First of foremost, profitability decreased from 1996 to 2000 where margins compressed from 4.4% to .87%. It should have been somewhat obvious to investors in 1997 when margins suddenly dropped from above 4% to .37%. The changing of accounting methods to mark to market and the utilization of SPEs provided a framework for Enron to overstate their earnings and profitability by 1. forecasting higher cash flows from certain projects 2. realizing financial gains on assets and 3. offloading bad debt to a private enterprise. Additionally, Enron's debt to equity ratio ballooned to 4.7x in 2000 from 2.5x the year prior. They saw an additional $30b of debt on the books year over year while shareholders equity remained relatively flat. Capital allocation is one of the most essential tasks for management teams and ROIC can be used as a key indicator. Per Chanos, Enrons economic value added is -2 to -5 percent which is the difference between a companies WACC and ROIC.

2. Based on your answer to question 1, explain how Enron escaped detection.

The use of mark to market account and the participation in SPEs made it easy for Enron to sway common investors into thinking nothing was wrong with the company. The footnotes embedded in their filings and the complexity of SPEs made it difficult for investors to fully understand the businesses operation and reporting methods. The use of off balance sheet items made it easy for Enron to trick investors into thinking they were generating more revenue then they actual were(classifying asset sales as recurring revenue). Touching on behavioral finance, analyst at these companies were 100% swayed by their companies involvement with Enron from a business standpoint as Enron was a massive client to some of these large investment banks. From an investors standpoint, Enron probably made a bunch of people rich during those 5 years leading up until their collapse and these investors probably had a bias towards the stock. Somewhat similarly to what we recently saw during the stock market rebound during Covid, many of these long duration/non profitable companies sky rocketed due to favorable monetary policy and core fundamentals were relatively ignored. Retail investors took an affinity to many of these names. Fast forward to last year when the Fed started hiking most of these unprofitable companies lost +75% of their stock value and wiped many shareholders out.