Discuss how accounts receivable can be analyzed

Answer 1

ANALYZING ACCOUNTS RECEIVABLE

The following considers financial statement presentation of accounts receivable, common financial ratios involving accounts receivable, and transfers of accounts receivable in exchange for cash.

Financial Statement Presentation

Accounts receivable appear on the balance sheet at the amount the firm expects to collect. This net amount is the gross amount of receivables less the amount in the Allowance for Uncollectibles.

Financial Ratios Involving Accounts Receivable

The financial statements contain information for analyzing the collectibility of accounts receivable and the adequacy of the expense for uncollectible accounts. Typical ratios used for this analysis include the accounts receivable turnover ratio, days receivables outstanding, and the write-off percentage.

The accounts receivable turnover ratio captures the speed of cash collections from credit customers. The ratio is sales revenue divided by average accounts receivable during the period. Although the numerator should include only credit sales, firms seldom disclose the proportions of cash and credit sales. Thus, typically the analyst uses total sales revenue in the numerator of the accounts receivable turnover ratio, recognizing that this assumption overstates the ratio.

The analyst often expresses accounts receivable turnover in terms of the average number of days between a credit sale and cash collection for that sale as days receivables outstanding.To calculate this ratio, divide 365 days by the accounts receivable turnover ratio.

Most firms that sell on account to other businesses, as opposed to consumers, collect cash within 30 to 90 days. Interpreting a firm's accounts receivable turnover and days receivables outstanding requires knowing the terms of sale. If the terms of sale are "net 30 days" and the firm collects its accounts receivable in 45 days, collections do not accord with the stated terms. This could be a signal that management should review and possibly change the firm's credit-granting policy and collection activity. If the firm offers terms of "net 60 days," a value of 45 for days receivables outstanding indicates that the firm is collecting its receivables faster than indicated by its contractual terms.

Because firms sell to customers on account as a strategy to stimulate sales, customers may purchase more if they know they need only sign their names. Firms may also permit customers to delay payment and thereby generate interest revenue through finance charges on the unpaid amounts. Thus, comparing accounts receivable turnover ratios over time or across firms requires an analysis of changes in sales revenue, interest revenue, changes in credit-granting and collecting policies, and the losses from uncollectible accounts. The analyst may also wish to analyze uncollectible accounts specifically.

Two ratios used to evaluate the allowance for uncollectibles are the ratio of Bad Debt Expense to Sales Revenue and the ratio of the Allowance for Uncollectibles to Accounts Receivable, Gross.

Transfers of Accounts Receivable in Exchange for Cash

In analyzing how a firm converts accounts receivable into cash, it is useful to establish whether the firm collects cash from its customers or transfers to others the receivables (the right to collect cash from customers) in exchange for cash. A firm that transfers its receivables in exchange for cash may show smaller (or no) accounts receivable, depending on the form of the transfer and the related accounting treatment.

At least three forms of transfer are possible. First, a firm may use its accounts receivable as collateral for a loan from a bank or other financial institution. The firm physically maintains control of the accounts receivable, collects cash from customers, and repays the loan. If the firm fails to repay the loan, the lender can claim the receivables. If the firm has used its accounts receivable as collateral for a loan, the firm will continue to show those receivables as an asset (and there will also be a loan payable liability). The firm should disclose the lending arrangement in its financial reports. Second, a firm may factor (sell) its accounts receivable to a bank or other financial institution in exchange for cash. In this case, the lender physically controls the receivables and collects cash from customers. Accounts receivable that the firm has factored do not appear on the balance sheet because the firm has sold them. Third, the firm may transfer the accounts receivable to a legally separate entity that issues debt securities to investors; the firm remits to investors the cash received from customers as those cash receipts occur. The firm may be obligated to make payments to investors in securities if the customers fail to make sufficient cash payments to pay the principal and interest on the debt securities. This third arrangement is a securitization, a process that transforms an asset (accounts receivable) into securities held by investors.

If one firm transfers its receivables and a comparison firm does not, the accounts receivable balances and related ratios of the two firms will not be comparable, despite similarities between the two firms in product markets.