Why Receivables Returns Matter to Investors
Investing Lesson: Analyzing a Balance Sheet
For companies to be successful, their customers need to pay for things on time. When customers purchase goods or services on credit and then pay quickly, companies are usually in better shape financially. They can put that cash in the bank, pay down their own debt, or use the money to start making new products.
When analyzing the balance sheet, investors can calculate how quickly customers are paying their credit bills, and this can offer insight into the health of the organization.
Receivable Turns Calculation
The receivable turns or accounts receivable turnover is a great financial ratio to learn when you are analyzing a business or a stock. It's common sense—the faster a company collects its accounts receivables, the better. Fortunately, there is a way to calculate how often a business collects its receivables. The formula looks like this:
Credit sales ÷ average accounts receivables = accounts receivable turns
Credit sales are found on the income statement, not the balance sheet. You'll have to have both the income statement and balance sheet in front of you to calculate this equation.
An Example of Calculating Receivable Turns
For this example, let's work with the hypothetical company H.F. Beverages. H.F. Beverages is a manufacturer of soft drinks and juice beverages. It sells to supermarkets and convenience stores across the country, and it offers its customers 30-day terms. That means the customers have 30 days to pay for the beverages they've ordered.
To see if customers are paying on time, you need to look for the income statement. It is normally found within a page or two of the balance sheet in a company's annual report or 10K. With the income statement in front of you, look for an item called "credit sales."
If you can't find "credit sales" on an income statement, you can use "total sales" instead. This won't give you as accurate a calculation, but it's still an acceptable figure to use.
In 2019, H.F. Beverages reported credit sales of $15,608,300. To figure out the average receivables, look at figures from 2019 and 2018. It had $1,183,363 in receivables in 2019, and in 2018, it reported receivables of $1,178,423.
Add the two receivables numbers ($1,183,363 + $1,178,423) and divide by two. This results in average accounts receivable of $1,180,893.
Now you have the figures you need to calculate the equation. Just plug the numbers in:
- Credit sales ÷ average receivables = accounts receivable turns
- $15,608,300 ÷ $1,180,893 = accounts receivable turns
- 13.2174 = accounts receivable turns
This means that H.F. Beverages collects its accounts receivable 13.2173 times per year on average.
Once you calculate this number, you can take the extra step of finding out the number of days it takes the average customer to pay their bills. Since there are 365 days in a year and the company gets 13.2174 turns per year, simply divide 365 by 13.2174. The answer is the number of days it takes the average customer to pay. In H.F.'s case, you should come up with roughly 27.62.
Interpreting the Result
Calculating the accounts receivable turns can quickly inform you of how well a company manages its accounts receivable. A poorly managed company allows customers to exceed the agreed-upon payment schedule. A well-managed company gets its customers to stick to the schedule.
In the case of H.F. Beverages, it appears the company is doing a good job managing its accounts receivable because customers aren't exceeding the 30-day policy. Had the answer been greater than 30, a wise investor will try to find out why there were so many late-paying customers. Late payments could be a sign of trouble, both in terms of management style and financial footing.
Keep in mind, you will need to read through the company's reports to find out what its collection deadline is. Not all companies require their customers to pay within 30 days.
The Bottom Line
Every company is different, and not all of them will conduct a significant portion of their sales on credit. However, many companies do regularly extend credit to customers. When they do, it's important to understand how effective they are at managing their customers' credit. A company that better manages the credit it extends may be a better choice for investors.