This post involves Financial Management. The analysis of financial statements is often conducted by lenders and investors. Their purpose is to determine whether it is sensible to provide the company with funding. The CFO should also perform financial analysis, but with the goal to diagnose operating challenges, measure performance, and improve efficiency. The remainder of the post concerns a very large portion of the assets of many companies – Accounts Receivable (AR). This asset represents the amount owed to the company for products sold or services rendered.
We classify the areas of AR analysis into 4 categories:
• Inherent Profit Margin
• Age of the Trade Receivables
• Reliability of AR
• Amount of Bad Debt recognition
The interpretation of these characteristics of AR is one of the most important tools for the CFO to gauge the performance of the business. This includes insights gained into sales growth strategy, credit policy, collections funding, and the state of the economy. To gain these insights we suggest the CFO:
1. Measure the Contribution Margin
2. Measure the age of AR
3. Measure the Bad Debt percentage
4. Compare Bad Debt to AR
The Inherent Profit Margin is also known as the Contribution Margin which is sales less variable costs, expressed as a percentage of sales. Note that fixed costs do not play a role in this calculation. If the contribution margin is high, the firm will have a relatively small proportion of cash invested in each receivable as the cash costs to sales, and thus to AR, are relatively low. Accordingly, any bad debt can be more easily offset by large cash and the company has incurred relatively low cash outflows when the receivable is written off. This provides the firm with the flexibility to offer generous payment terms to drive sales growth.
On the other hand, a small contribution margin implies a bad receivable will have a greater negative impact on the firm’s cash balance, as relatively large cash outflows will not be covered by the collection of an invoice. As a result, the company will need to carefully extend credit and mount vigorous oversight on collection efforts.
The age of AR is expressed in terms of days and is calculated as AR divided by (Annual Sales divided by 365). The resulting figure is known as Days Sales Outstanding (DSO). Typically DSO is monitored quarterly and the resulting trend is tracked. A decline in DSO may indicate the presence of such factors as invoices written off, conversion of AR into cash, conversion of accounts into loans, tighter credit policy, collection of a substantial invoice, or a slowdown in business. An increase in DSO may indicate the presence of such factors as looser credit policy, unwillingness to write off overdue invoices, or product issues. These are good and bad factors, thus it is important that the CFO determine the reason for the trend in DSO and its magnitude so that the proper decision can be made regarding corrective action.
Reliability of doubtful accounts is an assessment of the adequacy of reserves held against AR. These reserves (known as Allowance for Doubtful Accounts) are an estimate of the expected bad debts contained within AR. When examining this item the CFO should consider several factors:
• New products or entry into new markets that may not have sufficient information on bad debts that will occur
• A large number of customers on which the firm has no history makes realistic estimates of bad debt very difficult
• Tightening credit policy will probably cause allowance to fall; loosening credit policy will probably cause allowance to rise
• The amount of bad debt realized will change along with economic conditions and management’s response. For example, if there is a recession and management has not restricted credit, one can reasonably expect bad debts to increase
• Estimates of Bad Debt to be incurred could be manipulated in hopes of larger profits and bonuses.
The CFO must aggressively monitor the allowance for doubtful accounts and take prompt action based on an evaluation of the factors above.
Bad Debt as a percentage of AR should be tracked over time, usually on a quarterly basis. The appropriate amount is determined by nature of the industry, internal policies we have discussed, economic conditions, and quality of personnel. Thus the CFO should investigate deviations from historical levels of this ratio and determine the cause. To do this effectively we recommend the adoption of a standard procedure for calculating the amount of the allowance for doubtful accounts and adhering to this procedure.
The analysis of financial statements is often conducted by lenders and investors. Their purpose is to determine whether it is sensible to provide the company with funding. The CFO should also perform financial analysis, but with the purpose of diagnosing operating challenges, measure performance, and improve. Accounts Receivable (AR) represents the amount owed to the company for products sold or services rendered. The interpretation of AR is one of the most important areas for the CFO to gauge the performance of the business. This includes insights gained into sales growth strategy, credit policy, collections funding, and the state of the economy.