ANTHONY H. CATANACH JR. is an associate professor in the School of Business at Villanova University, as well as the Cary M. Maguire Fellow at the American College Center for Ethics in Financial Services. His professional experience includes five years as an audit manager with KPMG and six years in the financial services industry. Dr. Catanach has received numerous awards for his publication, teaching, and curriculum innovation efforts. He has authored numerous articles on a variety of accounting, finance, and management issues, as well as several business education texts..
Poor Overstock.com! The firm created an interesting business model that has attracted analyst criticism for years. Given all the attention, we just couldn’t resist taking a look ourselves, and the current vitals do not look good. Actually, as we shall soon see, that is an understatement!
Sam Antar has long asserted that the company has been involved in some accounting hanky-panky and insider trading. For example, Antar claimed that the CEO dumped some stock before a bad earnings report and misled investors as well. Antar currently thinks the firm is in a death spiral and appears ready to write its obituary.
And Sam is not alone. Writing for Seeking Alpha, Gary Weiss wrote about the apparent unreliability of Overstock’s accounting. Greg Greenberg at TheStreet.com thought it dumb for the Company’s CEO to say “it was an ugly end to an ugly year.”
So, we decided to take a look and see what the fuss is all about. We opened the Overstock 2011 10-K and indeed, it isn’t pretty. As our readers know, we’re traditionalists, so the first thing we did was to compute the Altman Z-score. After all, if you can’t find a pulse, there isn’t much use in testing for other signs of financial health. We applied Altman’s modified model for non-manufacturers as discussed in his 2002 paper, “Corporate Distress Prediction Models in a Turbulent Economic and BASEL II Environment”:
Z = 6.56 * WC/TA + 3.26 * RE/TA + 6.72 * EBIT/TA + 1.05 * BVE/TD
where WC = working capital, TA=total assets, RE=retained earnings, EBIT=earnings before interest and taxes, BVE=book value of equity, and TD=total debt.
The Z-score interpretation is straight-forward. If Z is greater than 2.60, then the firm has little financial distress and is healthy. The model predicts this firm will not fail. A Z-score between 1.10 and 2.60 is in the grey zone; it is indeterminate whether the firm will fail or not fail. The analyst should garner additional evidence to make this assessment. But, if the Z-score falls below 1.10, the model predicts corporate failure. And the lower the Z-score, the greater the amount of financial distress.
For Overstock, the metric has these values:
| Year | Z-Score |
| 2006 | -9.4 |
| 2007 | -7.0 |
| 2008 | -6.8 |
| 2009 | -2.6 |
| 2010 | -3.1 |
| 2011 | -7.3 |
Driving these results are the negative earnings before interest and taxes, as well as negative retained earnings. Some improvement occurs in 2009 and 2010, but a significant worsening takes place by the end of 2011. Additionally, and not surprisingly, the negative values also are driven by the erosion of shareholders’ equity. The debt/equity ratio rests at a staggering 12.56!
Sam, Gary, and Greg: if there’s room on the bandwagon, we are on board!
What more can we say? In pace requiescat.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.
J. EDWARD KETZ is an associate professor of accounting in the Smeal College of Business at Pennsylvania State University. He has a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D., all from Virginia Tech. Professor Ketz has been a member of the Penn State faculty since 1981. He also has taught at the University of Connecticut and the University of Maryland. Professor Ketz has authored and edited 17 books including Hidden Financial Risk (Wiley, 2003) which examines the corporate culture and the institutional setting that engendered recent accounting scandals. Dr. Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today. He also has appeared as an accounting commentator on CNN, National Public Radio, and Bloomberg Radio.
Hi, thank you for your comments. At what point would you expect the auditors to flag the situation with some sort of qualifier to the going concern opinion? Deeply negative Z scores and negative working capital situations have historically presaged non-going-concern opinions according to work done by Michael Maingot and Daniel Zeghal. With Overstock’s negative shareholder equity, worsening losses of income, reporting inconsistencies, and multiple debt defaults adding to the uncertainty surrounding the company, I would think that auditors would have the company on a short leash, no?
Interesting question for the auditors in this space. When would you qualify the audit opinion??
Hi Bill:
Overstock.com still has a small amount of shareholder’s equity, but I agree with your concerns.
Sam
Very well written!! I agree with your logic 100 hundred percent!! Nice change of pace from your EBTIDA articles!
Your analysis seems incomplete. You say that the “first thing” you did was to compute OSTK’s Z score (congrats) – was there a 2nd or 3rd thing you did? Don’t leave us hanging – I think your negative Z score = bad company analysis needs some help.
We can continue the analysis and the reporting of that analysis, and we’ll try to do that soon. We don’t want to leave you hanging!