Accounts receivable, or sometimes called trade receivables, is the amount owed by customers for the purchase of goods and services on credit. In other words, this account appears when the company has provided products or services but has not received cash payments.
You can find this account in the current assets section of the financial statements. It represents a potential source of cash inflows for the company apart from inventory sales. But, if customers cannot pay, it can’t be money. So, the company must ensure that money is collected from customers.
Why do companies have receivables?
Accounts receivable is sales facilities that the company provides to its customers. Customers could receive goods or services and without having to pay at that time.
But, the company requires customers to pay on time. Usually, the period is relatively short, ranging from a few days to about a year.
The company reports the accounts receivable as current assets. The company expects to collect cash payments within an accounting period. Therefore, this account represents a potential inflow of money to the company.
Why does the company provide credit facilities to customers
Most companies give relief for sale by offering credit facilities to customers. Typically, these facilities are only for loyal customers with a significant purchase.
Such facilities are for increasing customer transactions. Also, by offering sales on credit, the company strives to maintain good relations with customers.
Customers are happy with such facilities. They may often deal with companies in one year. Thus, such facilities can avoid the hassle of making payments every time transactions occur. They can collect purchase invoices and pay at once, instead of paying for each sale.
Why do you need to examine the company’s trade receivables?
Trade receivables are an essential aspect of a company’s financial analysis. It is one of the liquidity indicators, i.e., a measure of a company’s ability to cover short-term liabilities.
If a company can collect receivables, it means the company can raise money well. The better the ability to pay customers and the company’s ability to collect, it will secure the company’s liquidity position. In a sense, they can pay liabilities due during the accounting period.
But, if the company fails to collect receivables, the risk of liquidity increases. A possible consequence is that companies cannot pay short-term obligations, especially when cash is poor.
How do you record accounts receivable
The company reports trade receivables based on net realizable value. Simply put, it is the number of gross receivables reduced by uncollectible receivables (of allowance for doubtful accounts).
Let’s take a simple example. The company has trade receivables of Rp1,000. Of this amount, the company estimates that around 5% or Rp50 are uncollectible receivables.
In this case, the company will report the gross receivables of Rp950 (Rp1,000-Rp50) in its financial statement. This amount represents the money the company expects to collect from customers.
Too, if the company can’t collect the receivables. The company write off it from the balance sheet and reduce both gross receivables and allowance for doubtful accounts.
The calculation may be more complicated than the case above. Often, companies will categorize receivables based on their level of collectibility, usually based on the age category of receivables. Common categories are 0 to 30 days, 30 to 60 days, 60 to 90 days, and so on.
For each category, the company estimates the probability of the collectibility of accounts receivable. The company multiplies the probability value by the amount of receivables from each category. Then, the company sums each number to get a total allowance for uncollectible accounts.
Tips for analyzing trade receivables
You need to look at the trends in corporate receivables from time to time. There are various alternatives to evaluate the level of a company’s business debt.
- Evaluate the concentration of accounts receivable. You can divide it by customer, type of customer industry, or geographical area.
- Observe the age of accounts receivable. Ideally, most accounts receivable are short-lived, less than 30 days.
- Using accounts receivable turnover and days sales outstanding ratios.
Accounts receivable turnover ratio
You can calculate this ratio by dividing sales by the average trade receivables.
Accounts receivable turnover ratio = Sales / Average trade receivables
This ratio shows you how well the company uses and manages credit given to customers. The ratio also tells you how quickly short-term debt is collected or paid. A high ratio indicates efficient billing capabilities.
But, high ratios may also be due to overly strict credit or billing policies. Such a policy could harm future sales. Competitors can offer more flexible credit terms to customers. And, of course, customers can move away from the company to competitors.
To find out whether high ratios come from strict policies or not, you should compare the company’s sales growth with industry sales growth. If the company’s sales growth is lower than the industry, a high ratio indicates overly strict policies.
Days sales outstanding
This ratio shows you how long it takes for companies to collect payments.
To calculate it, you can divide the number of days in a year (say 365) by the accounts receivable turnover. Here is the formula:
Days of outstanding sales (DSO) = 365 / Accounts receivable turnover
For example, a DSO value of 30 implies that, on average, the company receives payment 30 days after the sale to the customer.
You can see, accounts receivable turnover is inversely related to DSO. The higher the accounts receivable turnover, the lower the DSO.
Low DSO is more desirable than high. The lower the DSO, the faster the company receives cash from credit sales.
In contrast, higher DSO could lead to liquidity problems. In a sense, the company has less cash to fund short-term business operations and pay off short-term liabilities.