How to analyze accounts receivable
Learn how to analyze accounts receivable and allowance for doubtful accounts like financial analysts do. Includes formulas and examples of financial analysis of accounts receivable.
1. Analysis of accounts receivable
The analysis of accounts receivable usually involves the following items:
- Size of accounts receivable
- Reasonableness of allowance for doubtful accounts
It is important to assess the size of accounts receivable to understand how much a company “invests” in its accounts receivable. As accounts receivable do not generate return beyond the discount period, companies should limit their investment in accounts receivable. In addition, it is important to assess the adequacy of the allowance for doubtful accounts.
2. Size of accounts receivable
From a seller’s standpoint, accounts receivable represent an investment because they involve a delay between delivery of goods or provision of services (i.e., sale) and collection of payment for them. So, accounts receivable are a form of trade credit.
Companies invest in accounts receivable to improve sales. However, over-investment in accounts receivable can be costly and can negatively affect companies. As the result, companies should establish an optimal level of accounts receivable. To monitor the investment in accounts receivable, companies may establish such practices as:
- Review credit policy and terms (e.g., due dates, discounts for early payments, collection procedures, credit standards)
- Assign credit limits
- Give cash discounts for prompt payments
- Charge interest on delinquent (overdue) payments
To evaluate accounts receivable, analysts can looks at the following ratios:
- Accounts receivable as a percentage of credit sales
- Collection period
Most public companies do not report the level of credit sales, and as the result, analysts usually use the sales value. This is a straightforward method: divide gross accounts receivable by sales.
Accounts Receivable as % of Sales = |
Accounts Receivable |
Sales |
In addition to calculating the accounts receivable as a percentage of sales, analysts can determine the time it takes to collect a receivable balance (i.e., the collection period). The collection period is calculated by dividing (gross) accounts receivable by average sales per day (i.e., sales divided by 365).
Average Sales per Day = |
Sales |
365 |
Collection Period = |
Accounts Receivable |
= |
Accounts Receivable x 365 |
Average Sales per Day |
Sales |
Let’s look at the following example. Au Logis Company (a fictitious entity) manufactures and sells home furniture and décor. Selected accounts receivable-related information for the company is presented below:
Au Logis Company |
||
20X2 |
20X1 |
|
Accounts receivable (gross) |
$28,000 |
$25,000 |
Allowance for doubtful accounts |
$4,000 |
$5,000 |
Sales |
$200,000 |
$250,000 |
Accounts receivable as % of sales |
14% |
10% |
Collection period |
51.1 days |
36.5 days |
By looking at the ratios, a negative trend in accounts receivable for Au Logis Company can be noted. The sales decreased while accounts receivable balance increased in 20X2. As the result, the accounts receivable as a percentage of sales ratio increased from 10% to 14%. Also, the collection period increased from 36.5 to 51.1 days. Au Logis Company has increased its investment in accounts receivable but is less quickly collecting the receivables.
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