Quality of Sales Ratio

The Quality of Sales Ratio is computed by dividing cash received from customers by sales (revenue):

Quality of sales = Cash received from customers / Sales

All other things being equal, a firm is in a more advantageous position if a large portion of its sales is collected in cash. Not only is final realization of the transaction assured, but the investment in accounts receivable is minimized.

This ratio is particularly useful for analyzing firms that use liberal revenue recognition policies or firms that, of necessity, employ revenue recognition policies that require the use of judgment. In both of these situations, a deterioration of this ratio over time might indicate that a firm is inflating earnings by the use of questionable accounting judgments. For example, some of Altron’s sales arise from firm contracts with other businesses for the design and manufacture of custom-made products.Although Altron records revenue at the time goods are shipped, it could argue for using the more liberal percentage-of-completion method. Utilizing this procedure too aggressively would likely result in recognizing significant amounts of revenue before cash is collected and would be reflected in a low quality of sales ratio.

The quality of sales ratio can also reflect a firm’s performance in making collections from customers.Suppose that a firm increases sales by the questionable strategy of reducing the credit standards that customers must meet.These customers are likely to be relatively tardy in making payments.This situation will be revealed to financial statement readers by a declining quality of sales ratio.

Altron’s quality of sales ratio cannot be computed from the information shown in Figure 4.4 in the section “Operating Activities – Using Cash Flow Information“. The reason is that the numerator, cash received from customers, is available only from the cash flow statement under the direct approach. However, this figure can be approximated by the following relationship:

Cash received
from customers
= Beginning balance in
Accounts Receivable
+ Sales Ending balance in
Accounts Receivable

To understand this relationship, recognize that both the beginning balance in accounts receivable and sales for the year might potentially be collected in cash during the current year. In fact, the sum of these two amounts is collected in cash, except for the balance that remains in accounts receivable at the end of the year.

Altron’s estimated cash collections from customers is $171,487 (in thousands).

Cash received
from customers
= Beginning balance in
Accounts Receivable
+ Sales Ending balance in
Accounts Receivable
$171,487 = $24,840 + $172,428 $25,781

Altron’s quality of sales ratio for 1997 is 99.5%.

Quality of sales = Cash received from customers / Sales

$171,487
$172,428

= 99.5%

This is a very high quality of sales ratio and reflects good accounts receivable management and conservative revenue recognition policies.

Case study 4.1 describes how the quality of sales ratio provides useful insights into the software industry.

Case Study 4.1

Several firms in the software industry have been criticized for their revenue recognition policies. The allegations suggest that these firms have recognized revenue prematurely. Such a practice would not only overstate sales, but net income as well.

Revenue overstatements can be achieved in various ways. Some companies were said to double-bill customers. Other companies booked revenue when they shipped goods to their own warehouses in foreign countries. Ultimately, such practices catch up with companies. For example, Oracle Corporation recently paid $24,000,000 to settle shareholder lawsuits, and Cambridge Biotech Corporation was forced to file for bankruptcy.

The quality of sales ratio can help investors detect and avoid such situations. Consider the following information for two software companies.

Cambridge Biotech Kendall Square Research
Accounts receivable (Dollars in thousands)
Beginning of year $ 5,951 $ 804
End of year 10,520 2,785
Sales for year 28,981 10,066

Required

a. Estimate the cash collected from customers for each firm.
b. Compute the quality of sales ratio for each firm.
c. What do you conclude from these ratios?

Solution

a. Cambridge Biotech Kendall Square Research
Sales $28,981 $10,066
Plus: Beginning accounts receivable 5,951 804
Less: Ending accounts receivable (10,520) (2,785)
Cash collected from customers $24,412 $ 8,085
b. Quality of sales = $24,412 $ 8,085
$28,981 $10,066
= 84% 80%
c. These ratios are considerably below 100%. This should certainly prompt financial statement readers to undertake further investigation.
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