The quality of accounts receivable is the likelihood that the cash flows that are owed to a company in the form of receivables are going to be collected. Analyzing the quality of accounts receivables for a company is important in assessing its financial health.
Understanding Accounts Receivables
Accounts receivable is the balance of funds that a company is owed from goods and services that they have sold; however, the goods and services have not yet been paid for. An example is when a customer buys a product on credit, meaning they still owe you the money for the products even though the risks and rewards of ownership have transferred.
Companies are willing to accept accounts receivable since it may entice more sales in situations where the customer does not have cash on hand but still wants to buy products and services.
Since the arrangement results in money owed to the company, it is represented as an asset. Accounts receivables are listed on the balance sheet as a current asset, and they are an important item in the operating assets of a company or working capital. They are assets and liabilities associated with the day-to-day operations of a company. Accounts receivables essentially represent a short-term IOU from customers.
Understanding Quality of Accounts Receivables
When customers receive goods and services from a company before paying, it is expected that they will eventually pay the company. However, there is a chance that some customers may not end up paying due to the customer’s financial health or simply being an unreliable customer. Since companies cannot expect 100% of accounts receivables to be collected, accountants have devised a contra asset account known as an allowance for doubtful accounts to record this estimated uncollectible amount.
An allowance for doubtful accounts is a contra asset account, meaning that it is tied to an asset on the balance sheet and is used to reduce it. Another example of a contra asset account is accumulated depreciation, which is used to reduce property, plant & equipment (PP&E) accounts. An allowance for doubtful accounts allows companies to reflect on their balance sheet the proportion of accounts receivables they do not expect to collect.
It also translates to an expense on the income statement known as a bad debt expense. A bad debt expense is related to accounts receivables and is the expensed representation of accounts receivables that are not expected to be collected.
Higher-quality accounts receivables will result in a lower allowance for doubtful accounts. Quality is an important aspect of accounts receivables and plays a large role in evaluating a company’s balance sheet. Companies with a poor quality of accounts receivables may encounter problems with liquidity and solvency in the future; therefore, it is best to analyze and measure the quality of accounts receivables.
How to Measure
Financial analysts use several methods to analyze the quality of the accounts receivables of a company.
One simple method of measuring the quality of accounts receivables is with the accounts receivable-to-sales ratio. The ratio is calculated as accounts receivable at a given point in time divided by its sales over a period of time. It indicates the percentage of a company’s sales that are still unpaid.
A high accounts receivable-to-sales ratio can indicate a risker company with a low quality of accounts receivable since it is not expected that all the accounts receivable will be collected.
Accounts Receivable Turnover Ratio
Another method for assessing the quality of accounts receivables is to analyze a company’s accounts receivables turnover ratio. Essentially, it is the inverse of the accounts receivable-to-sales ratio, but with a slight adjustment. It is calculated as the sales over a period of time divided by the average accounts receivables balance throughout that time.
The accounts receivable turnover ratio measures how quickly a company can turn its accounts receivable into cash. A high ratio usually means a higher quality of accounts receivables since it indicates that a company is turning receivables to cash faster.
Days Sales Outstanding (DSO)
Lastly, a third method to measure the quality of accounts receivables is with the days sales outstanding (DSO) ratio. It is calculated as average accounts receivables divided by sales, multiplied by 365. The DSO ratio gives insight into the average number of days it takes a company to convert its receivables into cash. Since it is in an understandable unit of measure (days), it is sometimes easier to use, as opposed to accounts receivable-to-sales ratio and the accounts receivable turnover ratio.
A shorter DSO means that the accounts receivables quality is higher since it means that a company can receive cash from its accounts receivables quicker. While a DSO ratio that is high – longer than 90 days – can be a sign that the receivables are becoming “stale” and may not be collected, which reflects the poor quality of corporate earnings.
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