The analysis of accounts receivable involves two issues:the relative size of accounts receivable and the adequacy of the allowance for uncollectible accounts. The financial statements of OB are used to illustrate these issues.
Size of Accounts Receivable – Because accounts receivable earn no return after the discount period has expired, firms should limit their investment in this asset. The size of accounts receivable is usually assessed relative to the amount of credit sales. This seems appropriate because credit sales give rise to accounts receivable. Most firms do not separately disclose credit sales, so net sales are usually used. A straightforward analysis divides gross accounts receivable by sales:
Accounts receivable as a percentage of sales = Accounts receivable (gross) / Sales
OB’s percentage increased from 5.8% in 1996 to 7.0% in 1997:
|Accounts receivable as a percentage of sales||$27,503 / $395,196
|$25,978 / $444,766
OB’s trend is not favorable. Notice that although sales declined from 1996 to 1997, the balance in accounts receivable actually increased. Although the unfavorable trend might be due to less effective management of accounts receivable, it could also be due to a changing sales pattern. If, in 1997, OB made a relatively larger proportion of its sales near year-end, we would expect to see an increase in year-end accounts receivable.
An alternative analysis involves calculating the average length of time it takes to collect a receivable.This is known as the collection period. It is calculated in two steps. First, calculate the average sales per day:
Average sales per day = Sales / 365
Next, the collection period is calculated by dividing gross accounts receivable by average sales per day.
Collection period = Accounts receivable (gross) / Average sales per day
This ratio indicates the number of days sales in accounts receivable.
OB’s collection period increased from 21 to 25 days. This is consistent with the analysis of accounts receivable as a percentage of sales.
Also note that food stores have a much shorter collection period than apparel manufacturers, which is due to the nature of food stores’ credit sales. Most credit sales are made via customers’ credit cards at major banks and food stores are able to collect these receivables from the banks very quickly. Some credit sales are made to businesses (such as restaurants and caterers), but these customers pay by check within a reasonable period of time.
Adequacy of Allowance for Uncollectible Accounts – Recall that writing off a specific account as uncollectible has no effect on total assets or net income. Assets and income are affected by the year-end adjustment in which uncollectible accounts are estimated. A great deal of judgment and discretion is used by management in making this estimate. Accordingly, analysts must carefully assess the reasonableness of the allowance for uncollectible accounts.
Few firms disclose their uncollectible accounts expense, yet most firms do disclose the year-end balance in the allowance for uncollectible accounts. The adequacy of this balance is usually assessed relative to the year-end accounts receivable balance. This is done by dividing the allowance by gross accounts receivable:
The reason for such a decrease is not entirely apparent. Perhaps OB made a conscious decision to decrease its sales to customers with dubious credit ratings. Such a change in the customer base would allow a decrease in the allowance for uncollectible accounts. Alternatively, recall from Chapter “The Income Statement,” that in 1997 OB ceased its European operations and terminated its relationship with certain domestic distributors. These changes altered the composition of OB’s customer base and might justify the decline in the allowance for uncollectible accounts.