© 2000 John Petroff

G- Analysis of accounts receivable

Accounts receivable are studied to determine how a firm converts sales into cash. Thus, it is an evaluation of its credit and collection policy. Major aspects of credit and collection have already been outlined in Chapter 4 Section A. An analysis of the quality of accounts receivable is necessary because lenders can only count on cash in company's bank account for repayment of their claims, not on promises from borrower's customers. But the analysis of accounts receivable must also look at accounts receivable as a tool to increase its sales. Failure to use such a tool, or using it too much, can be detrimental to a firm. Thus, the importance of its scrutiny by financial analysts beyond what is done for credit and collection purposes.

1)- Accounts receivable turnover

Liquidity of accounts receivable is usually first assessed with the help of an accounts receivable turnover ratio A/R Turnover:

A/R Turnover = Sales on Credit / Accounts Receivable

Let us verify the 1999 value of 7.35 for accounts receivable turnover of Timken shown in Timken_Ratios . Sales of $ 2,495 millions are taken from Timken Income Statement and accounts receivable of $ 339.3 millions are taken from Timken Balance Sheet for 1999. Timken's accounts receivable turnover is indeed A/R Turnover = 2,495 / 339.3 = 7.35

The accounts receivable turnover ratio indicates a firm's ability to generate sales from its investment in accounts receivable (A/R). Cash sales should be excluded from the numerator, but this is usually not possible for an outsider (as it is indeed not possible in any of the income statements used in this text). For the denominator, the ending A/R is most often used. Note, however, that in most cases, the ending A/R is also the minimum level of A/R because all firms choose to end their fiscal year at the lowest point of their seasonal selling activity. Additional knowledge would be gained by looking at the A/R level throughout the entire year; but information is rarely available to analysts other than the staff of the company itself. However, an inference can be made from quarterly reports which are normally available to banks, and from SEC filings for registered corporations. Normally, receivables from other than customers, i.e. those from employees, officers or subsidiaries, are not combined with trade receivables, but shown as part of other current assets. However, when analyzing a firm whose financial statements have not been audited, it would be wise to confirm the separation of other receivables from trade receivables. Sometimes, notes receivable from major clients are also shown separately from trade receivables. Then such notes should be added to the regular accounts receivables.

See review questions Q-8G.1 through Q-8G1.2.

2)- Days sales outstanding

Days sales outstanding (DSO) is also known as average collection period. It is calculated as

DSO = (Average A/R) / (daily sales)

or it can also be calculated with the turnover ratio

DSO = 365 / (A/R turnover)

See Note N-8G2.1.

When compared to the industry average, DSO is indicateive of the marketing strategy of the firm. When compared to the terms offered on the invoice of the firm, it indicates the efficiency of the collections department. It is clear that if DSO is much longer than the terms offered in company invoices, either the company is failing in its collection efforcement, or events are out of line with the planned strategy.

As example of calculation, let us verify the value of 49 days, given for days sales outstanding (DSO) in Timken_Ratios . With the first method of calculation we need the balance of accounts receivable of $ 339.3 millions from Timken Balance Sheet for 1999, and daily sales obtained by dividing 1999 sales of $ 2,495 millions taken from Timken Income Statement into 365, which gives $ 6.836 millions per day. Days sales outstanding is DSO = 339.3 / 6.836 = 49.63 or 50 days With the second method we just have to divide 365 by the accounts receivable turnover previously calculated as 7.35. Days sales outstanding is then DSO = 365 / 7.35 = 49.66 or 50 days.

See review questions Q-8G2.1 through Q-8G2.3.

3)- Receivables aging schedule

An aging schedule of accounts receivable is a statement grouping accounts receivable by the length of time they have been outstanding: 30 days, 60 days, 90 days and over. Such analysis reveals customers' paying difficulties, and is extremely useful because a strong correlation is known to exist between late payment and default. Unfortunately, this aging statement is not obtainable by an outsider (except for banks). What may be obtainable by an outsider, and shown in the balance sheet as a separate item or in notes to financial statements, is the amount of allowance for bad debt. This should be an indication of the extent of late payments. Observing a significant departure from prior years can be especially revealing. If a large proportion of open account customers fail to pay, accounts receivable are clearly much less liquid than they appear.

See review questions Q-8G3.1 through Q-8G3.3.

4)- Size of accounts receivable relative to total assets

The accounts receivable size is measured by dividing accounts receivable by total assets and it is normally calculated as part of the common size balance sheet. When compared over time this may indicate changes in marketing strategy of the firm. Another possible interpretation of growing accounts receivable is clients' difficulty to pay which should be investigated with the help of economic forecasts described in Chapter 15.

5)- Investigation of marketing strategy and quality of receivables

Table T-8.8 shows days sales outstanding and proportion of accounts receivable in total assets of three groups of American firms arranged by size. The three groups are taken from the data used throughout this chapter, and these particular industries were chosen because of the special information they appear to convey with regard to accounts receivable and inventory strategies.

Table T-8.5 clearly shows that for each of the industries in the sample, larger firms extend longer terms (shown as DSO in the table) to their customers than do smaller firms. This observation can be expected because cost of funds of larger firms is lower than that of smaller firms. Therefore, it is cheaper for the larger firms to use this method of boosting sales. However, in the case of pharmaceutical companies and machine manufacturers, a smaller proportion of funds is devoted to this strategy: accounts receivable as a percentage of total assets (shown as AR% in the table) decreases as the size of the firm increases. The conclusion is that only the larger furniture wholesalers have a deliberate strategy to take advantage of their size compared to smaller firms in the industry.

See review questions Q-8G4.1 through Q-8G5.2.

6)- Comparison of use of accounts receivable over time

Table T-8.7- shows the proportion of accounts receivable in total assets for selected years over the past 40 years for corporations in the United States. The data reveals that, while the proportion of other current assets has decreased, the proportion of accounts receivable has remained steady. This shows that American firms continue to rely on terms offered to customer as an important marketing tool.

See research assignments R-8G.1 through R-8G.3.

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