A Company’s Vital Signs—Accounts Receivable

Question: Many 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 examining the financial statements of a business or other organization, are there vital signs that should be studied as a routine matter?

Answer: Financial statements are extremely complex and most analysts have certain preferred figures or ratios that they believe to be especially significant when investigating a company. For example, previously, the current ratio and the amount of working capital were computed based on the amount of 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.

Both of these figures reflect a company’s ability to pay its debts and have enough monetary resources still 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 or other organization.

For example, on December 31, 2008, Avon Products reported a current ratio of 1.22 to 1.00 (current assets of $3.557 billion divided by current liabilities of $2.912 billion) while Caterpillar disclosed working capital of $4.590 billion (current assets of $31.953 billion less current liabilities of $27.363 billion).

Whether these numbers are impressive or worrisome usually depends on a careful comparison with (a) other similar companies and (b) results from prior years.

Question: Because this chapter deals with accounts receivable, what other vital signs might be studied specifically 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 payments being made as quickly as possible. Furthermore, as stated previously, 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 good 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 its average sales per day into the receivable balance. 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 divided by 365 to derive the amount sold 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 accounts. A significant change in the age of receivables will be quickly noted by almost any interested party.

age of receivables = receivables/sales per day

If a company reports sales for the current year of $7,665,000 and currently holds $609,000 in receivables, it requires twenty-nine 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 30, 2009, Dell Inc. reported net revenue of $61.101 billion. The January 30, 2009, net accounts receivable balance for the company was $4.731 billion, which was down from $5.961 billion as of February 1, 2008. The daily sales figure is calculated as $167.4 million ($61.101 billion/365 days). Thus, the average age of Dell’s ending receivable balance at this time was 28.3 days ($4.731 billion/$167.4 million).

A similar figure is referred to as the receivables turnover and is computed by the following formula:

receivables turnover = sales/average receivables.

For Dell Inc., the average receivable balance for this year was $5.346 billion ([$4.731 billion + $5.961]/2). The receivables turnover can be determined for this company as 11.4 times:

receivables turnover = $61.101 billion/$5.346 billion = 11.4.

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