Accounting: The Language of Business - Vol. 1 (Part 103)

Managers and investors alike must understand that accounting numbers are the beginning, not the end, of business valuation.

– Warren Buffett

 Financial Statement Analysis (Part C)

by

Charles Lamson

Accounts Receivable Analysis

The size and makeup of accounts receivable change constantly during business operations. Sales on account increase accounts receivable, whereas collections from customers decrease accounts receivable. Firms that grant long credit terms usually have larger accounts receivable balances than those granting short credit terms. Increases or decreases in the volume of sales also affect the balance of accounts receivable.

It is desirable to collect receivables as promptly as possible. The cash collected from receivables improves solvency. In addition, the cash generated by prompt collections from customers may be used in operations for such purposes as purchasing merchandise in large quantities at lower prices. The cash may also be used for payment of dividends to stockholders or for other investing or financing purposes. Prompt collection also lessens the risk of loss from uncollectible accounts.

Accounts Receivable Turnover

The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. This ratio is computed by dividing net sales by the average net accounts receivable. It is desirable to base the average on monthly balances, which allows for seasonal changes in sales. When such data are not available, it may be necessary to use the average of the accounts receivable balance at the beginning and the end of the year. If there are trade notes receivable as well as accounts, the two may be combined. The accounts receivable turnover data for Lincoln Company are as follows.

The increase in the accounts receivable turnover for 2023 indicates that there has been an improvement in the collection of receivables. This may be due to a change in the granting of credit or in collection practices or both.

Number of Days Sales in Receivables

Another measure of the relationship between sales and accounts receivable is the number of days' sales in receivables. This ratio is computed by dividing the net accounts receivable at the end of the year by the average daily sales. Average daily sales is determined by dividing net sales by 365 days. The number of days sales in receivables is computed for Lincoln Company as follows:

The number of days sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Comparing this measure with the credit terms provides information on the efficiency in collecting receivables. For example, assume that the number of days sales in receivables for Grant Inc.'s credit terms are n/45 [A net 45 (n/45) payment is a phrase that refers to an invoice that a customer must pay within 45 days.], then its collection process appears to be efficient. On the other hand if Grant Inc.'s credit terms are n/30, its collection process does not appear to be efficient. A comparison with other firms in the same industry and with prior years also provides useful information. Such comparisons may indicate efficiency of collection procedures and trends in credit management. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., 699-700*

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