Receivables

Receivables (often called Accounts Receivable or A/R) are essentially IOUs from a company’s customers. When a business sells goods or provides services on credit, it doesn't get the cash immediately. Instead, it records the amount owed as a receivable. This figure shows up on the company's Balance Sheet as a Current Assets, because it's expected to be converted into cash within a year. Think of it as a promise of future money. For an investor, understanding receivables is crucial because they represent sales that haven't yet turned into hard cash. While they are a normal part of business for many industries, they also carry the risk that the customer might pay late, or worse, never pay at all. A healthy-looking Revenue number can be misleading if the company is terrible at collecting the cash it's owed.

For a value investor, the receivables account is more than just a number; it's a window into the health of a company's operations and its relationship with its customers. A business with low or rapidly collected receivables is often a higher-quality business. Imagine a supermarket like Tesco or Kroger: you pay for your groceries before you leave. They have virtually no receivables from customers, which is a fantastic business model. In contrast, a company that builds airplanes or sells complex enterprise software might have to wait months to get paid, leading to a huge receivables balance. While this is normal for their industry, it introduces a layer of risk and complexity. A smart investor scrutinizes receivables to gauge how efficiently a company converts its sales into actual Cash Flow – the lifeblood of any business.

Not all receivables are created equal. A careful analysis can help you separate a company that's simply doing business from one that's heading for trouble.

Look out for these warning signs on the balance sheet:

• Growing Faster Than Revenue: This is a classic red flag. If a company's receivables are consistently growing at a faster pace than its sales, it could be a sign of trouble. It might mean the company is resorting to “channel stuffing” (pushing more product onto distributors than they can sell) or offering dangerously generous credit terms just to make its sales numbers look good. Essentially, they are “booking” sales that might never turn into cash.
• The Problem of Bad Debt: Sometimes, customers just don't pay. This uncollectible money is called Bad Debt. Companies anticipate this by setting aside a reserve, known as the Allowance for Doubtful Accounts, which is subtracted from the total receivables. An investor should watch this allowance closely. If it suddenly jumps as a percentage of total receivables, it could mean management is admitting that a larger portion of its IOUs has gone sour.

To get a clearer picture, investors use a simple but powerful tool:

• Days Sales Outstanding (DSO): This metric tells you the average number of days it takes for a company to collect payment after a sale is made. A lower number is almost always better.

The formula is: DSO = (Accounts Receivable / Total Credit Sales) x Number of Days in Period When looking at Days Sales Outstanding (DSO), always consider the context:

• Industry Comparison: DSO varies wildly between industries. A construction company's 90-day DSO might be normal, while a 30-day DSO for a retailer could be a sign of distress. Always compare a company's DSO to its direct competitors.
• Historical Trend: Is the company's DSO creeping up over time? A steady increase is a warning that customers are taking longer to pay, which can strain a company's cash resources.
• Customer Concentration: Are the receivables owed by a diverse group of customers, or are they concentrated with just one or two major clients? If a big customer defaults, it could be devastating.

Remember this: receivables are not cash. They are a promise of cash. As an investor, you should treat a large and growing pile of receivables with healthy skepticism. It's a sign of potential weakness that demands further investigation. Always dig deeper. Compare receivables growth to revenue growth, analyze the DSO trend against industry peers, and check for any sudden increases in the allowance for bad debts. A company that is disciplined and efficient at turning its sales into cash is often a healthier, more resilient, and ultimately more profitable investment.