A Company’s Vital Signs—Accounts Receivable

7.6 A Company’s Vital Signs—Accounts Receivable

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

Compute the current ratio, the amount of working capital, and other figures pertinent to the reporting of accounts receivable.
Describe the implications of a company’s current ratio.
Describe the implications of a company’s working capital balance.
Calculate the amount of time that passes before the average accounts receivable is collected and explain the importance of this information.
List techniques that a business can implement to speed up collection of its accounts receivable.

Current Ratio and Working Capital

Question: Individuals analyze financial statements to make logical and appropriate decisions about a company’s financial health and well being. This process is somewhat similar to a medical doctor performing a physical examination on a patient. The doctor often begins by checking various vital signs, such as heart rate, blood pressure, weight, cholesterol level, and body temperature, looking for any signs of a serious change or problem. For example, if a person’s heart rate is higher than expected or if blood pressure has increased significantly since the last visit, the doctor will investigate with special care. In analyzing the financial statements of a business or other organization, are there vital signs that should be measured and studied by a decision maker?

Answer: Financial statements are extremely complex and most analysts have certain preferred figures or ratios that they believe are especially significant when investigating a company. For example, in a previous chapter, both the current ratioFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by dividing current assets by current liabilities. and the amount of working capitalFormula measuring an organization’s liquidity (the ability to pay debts as they come due); calculated by subtracting current liabilities from current assets. were computed using the balances reported for current assets (those that will be used or consumed within one year) and current liabilities (those that will be paid within one year):

current ratio = current assets/current liabilities working capital = current assets – current liabilities

These figures reflect a company’s liquidity, or its ability to pay its debts as they come due and still have enough monetary resources available to generate profits in the near future. Both investors and creditors frequently calculate, study, and analyze these two amounts. They are vital signs that help indicate the financial health of a business and its future prospects.

For example, on December 31, 2010, Avon Products reported a current ratio of 1.42 to 1.00 (current assets of $4.184 billion divided by current liabilities of $2.956 billion), which was down from 1.84 to 1.00 at the end of 2009. On the same date at the end of 2010, Caterpillar disclosed working capital of $9.790 billion (current assets of $31.810 billion less current liabilities of $22.020 billion). Caterpillar’s working capital increased by over $1.5 billion from the previous year when it was reported as $8.242 billion.

Whether these numbers are impressive or worrisome almost always depends on a careful comparison with other similar companies and results from prior years.

Test Yourself

Question:

The Winsolie Corporation reports the following asset balances: cash—$4,000, accounts receivable, net—$17,000, inventory—$13,000, and land—$22,000. The company also has the following liabilities: salaries payable—$6,000, accounts payable—$4,000, note payable, due in seven months—$5,000, and note payable, due in five years—$14,000. What is the company’s current ratio?

1.400 to 1.000
1.931 to 1.000
2.267 to 1.000
3.733 to 1.000

Answer:

The correct answer is choice c: 2.267 to 1.000.

Explanation:

Current assets are usually those that will be used or consumed within one year. For this company, that is cash, accounts receivable, and inventory that total to $34,000. Current liabilities are debts that will be paid within one year: salaries payable of $6,000, accounts payable of $4,000, and note payable due in seven months of $5,000. The current liability total for this company is $15,000. Thus, the current ratio is $34,000 divided by $15,000 or 2.267 to 1.000.

Computing the Age of Accounts Receivable

Question: This chapter deals with the financial reporting of accounts receivable. What other vital signs might be studied in connection with a company’s receivable balance?

Answer: One indication of a company’s financial health is its ability to collect receivables in a timely fashion. Money cannot be put to productive use until it is received. For that reason, companies work to encourage customers to make payments as quickly as possible. Furthermore, as stated previously in this chapter, the older a receivable becomes, the more likely it is to prove worthless.

Thus, interested parties (both inside a company as well as external) frequently monitor the time taken to collect receivables. Quick collection is normally viewed as desirable, whereas a slower rate can be a warning sign of possible problems. However, as with most generalizations, exceptions do exist so further investigation is always advised.

The age of a company’s receivables is determined by dividing the receivable balance by the average sales made per day. Credit sales are used in this computation if known, but the total sales figure often has to serve as a substitute because of availability. The sales balance is first divided by 365 to derive the amount of sales per day. This daily balance is then divided into the reported receivable to arrive at the average number of days that the company waits to collect its money. A significant change in the age of receivables will be quickly noted by almost any interested party.

age of receivables = receivables/sales per day

For example, if a company reports sales for the current year of $7,665,000 and currently holds $609,000 in receivables, it requires 29 days on the average to collect a receivable.

sales per day = $7,665,000/365 or $21,000 age of receivables = $609,000/$21,000 or 29 days

As a practical illustration, for the year ended January 28, 2011, Dell Inc. reported net revenue of $61.494 billion. The January 28, 2011, net accounts receivable balance for the company was $6.493 billion, which was up from $5.837 billion the year before. The daily sales figure is $168.5 million ($61.494 billion/365 days). Thus, the average age of Dell’s ending receivable balance at this time was 38.5 days ($6.493 billion/$168.5 million). By itself, this figure is neither good nor bad. An assessment depends on the terms given to customers, the time of collection in other recent years, and comparable figures for companies in the same industry as Dell.

A similar figure is referred to as the receivables turnoverFormula measuring speed of an organization’s collection of its accounts receivable; calculated by dividing sales by the average accounts receivable balance for the period. and is computed by the following formula:

receivables turnover = sales/average receivables.

For Dell Inc., the average receivable balance for this year was $6.165 billion ([$6.493 billion + $5.837]/2). The receivables turnover for Dell for this period of time was 9.97 times:

receivables turnover = $61.494 billion/$6.165 billion = 9.97.

The higher the receivable turnover, the faster collections are being received.

Test Yourself

Question:

The Yang Corporation recently extended the time that customers are given to pay their accounts receivable. Investors are interested in the impact of that decision. In Year One, the company had $730,000 in sales with $58,000 in accounts receivable on hand at the end of the year. In Year Two, sales grew to $1,095,000 but accounts receivable also rose to $114,000. Which of the following statements is true?

The receivables turnover for Year Two was 9.61 times.
The age of the receivables at the end of Year Two was thirty-three days.
The receivables turnover for Year Two was 10.18 times.
The age of the receivables at the end of Year Two was thirty-eight days.

Answer:

The correct answer is choice d: The age of the receivables at the end of Year Two was thirty-eight days.

Explanation:

The receivables turnover for Year Two is the sales for the year ($1,095,000) divided by the average receivable balance of $86,000 ([$58,000 + $114,000] divided by 2). The receivables turnover is 12.73 ($1,095,000/$86,000). Computing the age of receivables begins by calculating the average sales per day as $3,000 ($1,095,000/365 days). That figure is divided into the ending receivable of $114,000 to arrive at thirty-eight days. On average, that is the time between a sale being made and cash collected.

Reducing the Time It Takes to Collect Receivables

Question: If members of management notice that the average age of accounts receivable Formula measuring the average length of time it takes to collect cash from sales; calculated by dividing either accounts receivable at a point in time or the average accounts receivable for the period by the average sales made per day. for their company is getting older, what type of remedial actions can be taken? How does a company reduce the average number of days that are required to collect receivables so that cash is available more quickly?

Answer: A number of strategies can be used by astute officials to shorten the time between a sale being made and cash collected. The following are just a few common examples. Unfortunately, all such actions have a cost and can cause a negative impact on the volume of sales or create expenses that might outweigh the benefits of quicker cash inflows. Management should make such decisions with extreme care.

Require a tighter review of credit worthiness before selling to a customer on credit. If sales on account are only made to individuals and companies with significant financial strength, the quantity of delayed payments should decline.
Work to make the company’s own accounting system more efficient so that bills (sales invoices) are sent to customers in a timely manner. Payments are rarely made—even by the best customers—before initial notification is received. If the billing system is not well designed and effectively operated, that process can be unnecessarily slow.
Offer a discount if a customer pays quickly. This action has an obvious cost, but such reductions provide a strong incentive to the customer for fast action.
Send out second bills more quickly. Customers often need reminding that a debt is due. An invoice marked “late” or “overdue” will often push the recipient into making payment. A company might decide to send out this notice after 30 days—as an example—rather than wait for 45 days.
Instigate a more aggressive collection policy for accounts that are not paid on time. Companies use numerous strategies to “encourage” payment and begin applying these steps at an earlier point in time.

Most companies monitor the age of receivables very carefully and use some combination of these strategies whenever any sign of problem is noted.

Key Takeaway

Decision makers analyzing a particular company often look beyond reported balances in search of clues as to financial strengths or weaknesses. Both the current ratio and the amount of working capital provide an indication of short-term liquidity (ability to pay debts as they come due) and profitability. The age of receivables and the receivables turnover are measures of the speed of cash collections. Any change in the time needed to obtain payments from customers should be carefully considered when studying a company. Management can work to shorten the number of days it takes to receive cash by altering credit, billing, and collection policies or possibly by offering discounts or other incentives for quick payment.

Talking with a Real Investing Pro (Continued)

Following is a continuation of our interview with Kevin G. Burns.

Question: Let’s say that you are analyzing a particular company and are presently looking at its current assets. When you are studying a company’s accounts receivable, what types of information tend to catch your attention?

Kevin Burns: I look at three areas specifically. First, how long does it take for the company to collect its accounts receivable especially compared to previous periods? I really don’t like to see radical changes in the age of receivables without some logical explanation. Second, how lenient is the company in offering credit? Are they owed money by weak customers or a small concentration of customers? Third, does the company depend on interest income and late charges on their accounts receivable for a significant part of their revenue? Some companies claim to be in business to sell products but they are really finance companies because they make their actual profits from finance charges that are added to the accounts receivable. It is always important to know how a company earns money.

Video Clip

(click to see video)

Professor Joe Hoyle talks about the five most important points in Chapter 7 "In Financial Reporting, What Information Is Conveyed about Receivables?".