Investment ABCs - Accounts Receivable

Because there are many accounting terms used in the investment community that you should be familiar with as an investor, I am publishing a series of articles intended to highlight some important accounting issues and how they relate to the evaluation of stocks. This is the second article of the series.

My previous article discussed working capital, how it is calculated, and its importance to investors. A key component of working capital is accounts receivable. A simple examination of a company's accounts receivable balance and the changes in the balance over time can often provide early indications of serious impending problems. Being a successful investor often depends as much on staying away from bad investments as finding and investing in the good ones.

Accounts receivable is essentially the amount of money owed to the company by its customers. In the normal course of operations, most businesses provide their customers a period of 30 to 60 days to pay for products and services. The accounts receivable balance can be found on the company's balance sheet under the heading of "current assets."

The following are some quick calculations and tests that you can use to examine a company's accounts receivable balance for potential problems:

Your examination of a company's accounts receivable should start with a look at the changes in the company's accounts receivable balance over time. Any change in the accounts receivable balance in excess of 15-20% over the course of a year should have a valid reason, such as a general increase in sales activity, the completion of a major sale immediately prior to the current balance sheet date, or a recent acquisition. If the increase is due to an acquisition or a general rise in sales activity, the percentage increase in accounts receivable should be similar to the percentage growth in overall revenues. An accounts receivable balance that is growing at a rate in excess of the company's sales growth without a logic explanation, can often be an indication that the company is having difficulty collecting from a major customer, or even worse, from a group of customers, thereby suggesting the possibility that the company's industry as a whole may be experiencing some problems. Difficulty in collecting from a customer could lead to the write-off of the balance receivable or a provision for a bad debt during the company's next audit. Such an event could have a significant negative impact on the company's working capital position, not to mention its earnings, and consequently its stock price.

Some analysts use the Receivables Turnover Ratio as a tool to assess changes in the accounts receivable balance over time. While the method of calculating the ratio can vary from analyst to analyst, the following works well in most circumstances:

Receivables Turnover Ratio = (Sales for Latest Quarter X 4) / Accounts Receivable

To make the ratio a little easier to understand, it is often expressed as the Average Age of Receivables, which is calculated as follows:

Average Age of Receivables (days) = 365 / Receivables Turnover Ratio

The Average Age of Receivables tells you how many days on average that it takes customers to pay for the goods and services they purchased from the company. What is considered a normal ratio varies considerably from industry to industry. A cash-based business such as a hot dog stand would generally have very little or no receivables. As a result, its receivables turnover should be very high, and consequently, the average age of receivables, very low - perhaps only a day or two at the most. On the other end of the spectrum. a company that sells high-end specialty computer components to the government pursuant to large contracts, is likely to have a much lower receivables turnover and consequently a much higher average age of receivables -perhaps 45-60 days. More important than the specific numbers is the change in these numbers over time. A receivables turnover ratio that is getting smaller each quarter and an average age of receivables figure that is steadily rising, can be a warning signal that the company is having difficulty collecting from certain customers. In such circumstances, you should seek a valid explanation from the company.

As a part of overall receivables risk (the likelihood of a bad debt arising), many analysts also examine the "quality" of a company's receivables by evaluating the credit worthiness of its major customers. Companies whose customers primarily include very large established "blue-chip" corporations and government agencies generally have far less receivables risk than those who sell their goods and services principally to small start-up businesses or lesser known offshore enterprises. If the analyst comes to the conclusion that the company's receivables quality is leaning towards the higher risk end of the scale, he will generally monitor changes in the company's accounts receivables balance on a much closer basis.

Grant Robertson, B.B.A.

Disclaimer: The author is not a registered investment advisor. Accordingly, this article is presented for educational and information purposes only. Those seeking specific investment advice should consult a registered investment advisor. You are urged to consult your investment advisor before embarking on any new investment strategy as the strategies depicted in this article may not be suitable for all investors.