It seems like in every line of study, there’s one big cautionary tale that gets told over and over across the years to highlight the dangers inherent in the field.
In my undergraduate engineering program, it was the Challenger disaster. We studied Thiokol engineer Roger Boisjoly and his objections to the cold January launch that resulted in one of the most high-profile and devastating engineering disasters of the space era. We used the Challenger story as a jumping off point for discussions on engineering ethics and the importance of clear communication (see: Richard Feynman famously dropping rubber into ice water). It was a formative topic on what can happen when mistakes are allowed to pile up and compound.
In my business program, the ethical investigation centered around one of the most high-profile, devastating corporate collapses in history: Enron.
At the turn of the century, Enron was a burgeoning corporate darling. They were winning awards for innovation, making massive gains in share price, and aiming to take over the entire business world with their ever-expanding markets in energy and beyond. Their shares hit an all-time high price of $90.75 in the summer of 2000, but by the time we opened Christmas presents in 2001, just a single year later, Enron was dead. Over the years, investigations into what in the world happened at Enron revealed a complex web of financial misrepresentation, outright deception, and absolutely deplorable behavior from the very bottom ranks all the way up to the C-suite.
So that’s the playing field. There’s a lot to say about Enron, and many different perspectives we could take. But this isn’t Travis’ Corporate History Corner or Travis’ Business Ethics Forum, it’s a “finance mini-lesson.” Even restricting ourselves to that vantage point, there’s plenty to learn from here.
I’m always talking about how financial data is useful for answering real, interesting questions, and not just deciding whether or not to shed your company stock. Today, we’re going to take a critical look at Enron’s financial reporting and follow the breadcrumbs that led a handful of corporate analysts and business reporters to begin unwinding the web of lies that supported Enron. Using what we’ve learned previously, would you be able to spot these irregularities and see through the shining public image of a dubious, faltering giant? Let’s find out!
While there are heaping piles of figures we could look at to illustrate Enron’s financial woes, we’re going to look at just three. While they’re three of the most basic, which should be accessible to long-time readers of these lessons, they’re also three of the most telling, quickly highlighting Enron’s problems using a strictly numbers-based approach.
Much of the supporting material for this post comes from the publication “Red Flags in Enron’s Reporting of Revenues and Key Financial Measures,” from Bala G. Dharan, PhD/CPA, and William R. Bufkins, CCP. The full report can be found here: http://www.ruf.rice.edu/~bala/files/dharan-bufkins_enron_red_flags.pdf
I suggest the full report for further reading.
Let’s begin.
- Gross Margins
In the lesson What’s in a Margin?, we discussed the three most prominent types of “margins” used to assess a business’s health, and what each of them means individually as well as within the context of the full set. In that lesson, I said:
Gross margin corresponds with the strength of our business model.
Keep that in mind as we look at Enron’s top-level margins from 1996-2000:
Here we see massive revenue growth over 4 years (almost ten times!), but anemic gross profit growth (just over two times). This is shown in the steady dilution of gross profit margin. Many businesses highlight revenue as a key figure in showing health, and Enron was the standard-bearer of this metric. They bragged about all the markets they were entering, how much business they were doing, and just look at that revenue growth – 251% in the year 2000 alone.
I feel like maybe I’ve downplayed the importance of revenue in the past. Revenue is the start of everything. Increasing revenue means we’re doing more stuff, and doing more stuff is usually a good sign. It’s a catalyst for growth and a sign that there’s demand for our business in the marketplace.
But remember, gross margin shows the strength of our business model. If revenue is increasing, it means we’re doing more stuff, but if our gross margins are declining, it just means we’re doing more of the wrong stuff. Enron’s obsessive focus on increasing revenues and showing off revenue growth served to distract from the very obvious fact that their growth was not healthy or profitable.
Gross margins should have been the first sign of this, but operating and net margins also showed massive declines as the Enron bubble inflated.
- Cash Flow
We’ve talked at length about the importance of cash in a business. At the end of the day, profit is just a number on a calculator, but cash moving in and out of the corporate coffer is real.
Here’s where the more direct manipulation from Enron’s top brass comes into play. Mysteriously, they focused on ensuring that annual cash flows showed positive, while leaving breadcrumbs in the quarter-to-quarter results.
Check out the cash flow from operations quarterly data for the year 2000:
In earnings analysis, adding “from operations” to any figure basically means focusing in on the core business. Big companies, especially publicly traded ones, have a lot of things going on financially. The “from operations” designator says “this figure is from repeatable stuff accomplished from our core business operations, rather than discontinuous activities that might vary over time.” This makes it especially important for analyzing growth trends and assessing the company’s place in the market.
On the table above, you can see Enron absolutely hemorrhaging cash from their continued operations in the first two quarters, then executing a somewhat realistic (but impressive) turnaround in the third quarter and a… wait… what in the world… your cumulative cash flow going into Q4 was $100M and you ended the year at almost FIVE BILLION?
You would have to grow extra eyebrows to be able to raise enough of them at this figure.
- Investing Activity
In the last section, we saw that there was something fishy about cash flows. Now, we’ll look at how that manipulation was accomplished. Top-level cash flows were controlled in two primary ways: debt and equity.
Taking on debt is a positive source of cash with an offsetting liability. You get cash now, but make payments along the way. But those are on different pages of the financial report so you can try to hide it by squirreling away debt on the balance sheet and highlighting your awesome cash flows. Very novice level ratio analysis would uncover this, but Enron had a strong façade, dissuading critical inspection. To give analysts some credit, Enron additionally cheated this system by hiding its debt in an unending stream of special purpose entities and shady shell corporations that were nearly impossible to unravel.
Equity is using your shares as a financial device and issuing stock, which dilutes per-share value but gives you immediate cash. As we’ve talked before with share repurchases, selling more shares is generally not a good sign; it means organic growth isn’t proving sufficient to support the business. Because Enron’s shares were valuable, they had easy access to equity cash, since banks were of course happy to be part of the rampaging Enron train and investors were gobbling up the vogue stock of the time. So, Enron had cash because its shares were valuable, and its shares were only valuable because they had access to cash… which came from selling shares… see the house of cards being built here?
Both of these activities, as well as some other more complicated ones, are what we would call investingactivities, which are separate and distinct from operating activities. Remembering how operating cash flows are critical in highlighting core business performance and trends, check out what happens to Enron’s total cash flow (from both sources) when the investing component is taken out:
Blam.
Oh, and the positive $515M in 2000 actually ignores $2.35B in repayments to California utility customers, so that one should actually be negative $1.835B. That’s over eight billion dollars in cash lost by the business segments that Enron claimed were making it rich.
They were supporting themselves strictly with debt and equity issuance, while bleeding literal billions out from their meager operations – operations which, despite a ton of media hype over big, tenacious projects, were anemic at best and pure, uncovered losses at worst. Famously, they had used sneaky accounting to book millions in future profits on a power plant that never once turned on. And that was just one of many instances.
We’ve covered a tiny sliver of the insanity that was Enron. I hope this has been an illustrative and informative look into an applied use of finance that some might call forensic accounting. If you’re interesting in learning more about the fascinating, though tragic tale of Enron, I strongly suggest the documentary Enron: The Smartest Guys in the Room. It’s currently available on Netflix. Additionally, for a bit more depth on the financial side, check out the report that I referenced for this lesson here.