Accounts Receivable

Accounts Receivable (also known as Trade Receivables or simply AR) is the money owed to a company by its customers for goods or services that have been delivered but not yet paid for. Think of it as the company's official 'IOU' list from its clients. When you buy a coffee, you pay immediately—that's a cash sale. But when a large manufacturer sells a million dollars worth of machinery to another company, it often gives the buyer 30, 60, or even 90 days to pay. During that time, the million dollars is logged as an 'account receivable'. It shows up on the company's Balance Sheet as a Current Asset because it's expected to be converted into cash within one year. For investors, Accounts Receivable is a crucial line item. It's a direct reflection of a company's sales and its relationship with its customers, but it also carries the risk that some of those IOUs might never be paid back.

Understanding Accounts Receivable is as simple as following a single sale. Let's imagine 'Clever Widgets Inc.' sells a batch of 1,000 widgets to 'Big Retail Corp.' for €10,000 on January 1st. Clever Widgets extends credit terms, giving Big Retail 30 days to pay the invoice. Here’s the journey of that €10,000:

• Day 1 (The Sale): Clever Widgets ships the widgets. It immediately records €10,000 in Revenue on its Income Statement and €10,000 in Accounts Receivable on its Balance Sheet. Notice that no cash has changed hands yet, but from an accounting perspective, the sale has been made.
• Day 1 to Day 29 (The Waiting Game): The €10,000 sits in the Accounts Receivable account. It represents a legal claim Clever Widgets has on Big Retail's cash.
• Day 30 (Payday): Big Retail pays its invoice. Clever Widgets receives €10,000 in cash. On the Balance Sheet, the Cash account increases by €10,000, and the Accounts Receivable account decreases by €10,000. The IOU is now settled.

This cycle is a vital part of a company's Working Capital management.

For a value investor, AR is much more than just a number; it's a window into a company's operational health and management quality. While offering credit can boost sales, it's a double-edged sword. It ties up cash that could be used for other purposes (like paying suppliers or investing in new projects) and introduces the risk of bad debt—the unfortunate reality that some customers will never pay. A savvy investor scrutinizes AR to uncover potential risks and opportunities that others might miss.

Not all receivables are created equal. The key is to determine if the company is likely to collect the money it's owed. One of the most powerful and simple checks is to compare the growth rate of Accounts Receivable to the growth rate of Revenue. If a company's revenue grows by 5% in a year, but its Accounts Receivable shoots up by 30%, it's time to put on your detective hat. This could signal several problems:

• Aggressive Sales Tactics: The company might be offering very generous credit terms (e.g., “buy now, pay in 6 months!”) just to report higher sales figures. This can attract lower-quality customers and is often unsustainable.
• Struggling Customers: The company's customers might be facing financial trouble and are taking longer to pay their bills. This is a major risk, especially in an economic downturn.
• Channel Stuffing: In a worst-case scenario, it could indicate a fraudulent practice called channel stuffing, where a company sends more products to its distributors than they can actually sell, just to inflate short-term sales numbers.

Another critical area to examine is the Allowance for Doubtful Accounts. This is a reserve account on the balance sheet where a company estimates how much of its AR it doesn't expect to collect. An honest management team will make realistic provisions. Be wary if this allowance shrinks as a percentage of total receivables, especially when AR is ballooning or the economy is weak. It might mean management is trying to make its earnings look better than they really are.

To quantify your analysis, two key ratios are indispensable.

Days Sales Outstanding, or DSO, tells you the average number of days it takes for a company to collect cash after making a sale.

• Formula: DSO = (Accounts Receivable / Total Credit Sales) x Number of Days in Period (usually 365)

A low and stable DSO is like a well-oiled machine—it shows the company is efficient at collecting what it's owed. A suddenly spiking DSO, however, suggests the collection machine is getting rusty. It's a clear warning sign that you need to investigate further. Always compare a company's DSO to its own historical numbers and to its industry peers, as collection times can vary significantly between sectors.

This ratio measures how efficiently a company uses its assets by showing how many times per year it collects its average accounts receivable.

• Formula: Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable

A higher turnover ratio is generally better. It indicates that the company has a high-quality customer base that pays its debts quickly and that its credit and collection processes are effective. A declining turnover ratio, on the other hand, suggests the opposite and warrants caution.