In studying financial statements, investors often focus on revenues, net income, and earnings per share. Although investigating a business’s revenues and profits is a good way to get a picture of its overall health, analyzing the accounts receivable allows you to go a step deeper in your analysis.
Accounts Receivable: What Is It and Why Does It Matter?
In the simplest terms, accounts receivable measures the money that customers owe to a business for goods or services already provided. Because the business expects the money in the future, accountants include accounts receivable as an asset on the business’s balance sheet. (Learn more in Breaking Down the Balance Sheet). However, most businesses do not expect to collect 100 percent of the money shown in accounts receivable.
Given this risk of non-payment, why do business continue providing goods and services without requiring payment in advance? When dealing with regular and reliable customers, a business can benefit from selling its goods and services on credit. It may be able to make more sales that way and also reduce transaction costs. For example, the business can invoice reliable customers periodically instead of processing numerous small payments.
The problem is when accounts receivable reflects money owed by unreliable customers. Customers can default on their payments, forcing the business to accept a loss. In order to account for this risk, businesses base their financial reporting on the assumption that not all of their accounts receivable will be paid by customers. Accountants refer to this portion as the allowance for bad debts.
On face value, it is impossible to know whether the accounts receivable of a business are indicative of healthy or unhealthy business practices. Investors can only gain this knowledge through careful analysis.
How to Analyze Accounts Receivable
Over the years, analysts have developed many different methods to uncover the underlying quality of a business’s accounts receivable.
One of the simplest methods available is the use of the accounts receivable-to-sales ratio. This ratio, which consists of the business’s accounts receivable divided by its sales, allows investors to ascertain the degree to which the business’s sales have not yet been paid for by customers at a particular point in time. A higher figure suggests that the business may have difficulty collecting payments from its customers.
Another simple method consists of examining the manner in which the business’s allowance for bad debts has changed over time. This allowance is typically reported in the notes to the financial statements, although it is sometimes included in the balance sheet. If the allowance for bad debts has grown substantially, the business may suffer from a structural deficiency in regard to its ability to collect payments from its customers. At the same time, dramatic declines in the allowance for bad debts may indicate that the business’s management has had to write off portions of their accounts receivable altogether.
Read the Notes to the Financial Statements
Other methods of analysis are more demanding. For example, the notes to the financial statements may mention specific customers with outstanding debts. Collect these names and investigate the credit worthiness of each debt-owing customer individually. You can then estimate the likelihood of each customer repaying its portion of the business’s accounts receivable. Although this analysis can yield valuable insights, it can also be time consuming, as the process of estimating credit worthiness can become highly complex.
A more accessible method for assessing the quality of a business’s accounts receivable consists of analyzing the degree to which the business’s debtor customers are diversified by industry sector. A business whose accounts receivable are owed by customers concentrated within a particular sector may be vulnerable to default in the event of an economic downturn affecting that sector. Conversely, a business whose accounts receivable are owed by a highly diversified customer base may be less vulnerable, based on the premise that an economic downturn in any particular sector is unlikely to materially affect the repayment rate of its accounts receivable as a whole. (Learn more in The Importance of Diversification).
As an extension of this logic, investors may consider a business to be relatively secure if each of its debtor customers owes only a relatively small portion of its accounts receivable. Under such conditions, a default by any one of its customers would be unlikely to exert a significant impact on the business’s overall financial health.
Finally, another common method of analysis consists of investigating the extent to which each of the customers is overdue on their payments. This technique, called “aging” the accounts receivable, can help answer the question of whether problems with specific customers have existed over the long term. As with most methods, this analysis yields more informative results if investors perform it using data from an extended timeframe.
The Bottom Line
In addition to the techniques described above, there are many more ways to analyze accounts receivable. Although individual investors will disagree over the best method, few would debate that the analysis of accounts receivable is a critical component of investment due diligence.