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Analysis of Accounts Receivable in Financial Accounting

The analysis of accounts receivable involves two issues:the relative size of accounts receivable and the adequacy of the allowance for uncollectible accounts. The financial statements of OB are used to illustrate these issues. Figure 5.5 contains some basic information about OB’s receivables.

Figure 5.5 - Financial Statement Information

Size of Accounts Receivable - Because accounts receivable earn no return after the discount period has expired, firms should limit their investment in this asset. The size of accounts receivable is usually assessed relative to the amount of credit sales. This seems appropriate because credit sales give rise to accounts receivable. Most firms do not separately disclose credit sales, so net sales are usually used. A straightforward analysis divides gross accounts receivable by sales:

Accounts receivable as a percentage of sales = Accounts receivable (gross) / Sales

OB’s percentage increased from 5.8% in 1996 to 7.0% in 1997:

	1997	1998
Accounts receivable as a percentage of sales	$27,503 / $395,196 = 7.0%	$25,978 / $444,766 = 5.8%

OB’s trend is not favorable. Notice that although sales declined from 1996 to 1997, the balance in accounts receivable actually increased. Although the unfavorable trend might be due to less effective management of accounts receivable, it could also be due to a changing sales pattern. If, in 1997, OB made a relatively larger proportion of its sales near year-end, we would expect to see an increase in year-end accounts receivable.

An alternative analysis involves calculating the average length of time it takes to collect a receivable.This is known as the collection period. It is calculated in two steps. First, calculate the average sales per day:

Average sales per day = Sales / 365

Next, the collection period is calculated by dividing gross accounts receivable by average sales per day.

Collection period = Accounts receivable (gross) / Average sales per day

This ratio indicates the number of days sales in accounts receivable.

OB’s collection period increased from 21 to 25 days. This is consistent with the analysis of accounts receivable as a percentage of sales.

Figure 5.6 contains a comparison of OB’s ratios with Hartmarx Corporation, another apparel manufacturer, and, as a point of contrast, with Albertson’s, a food store. OB’s accounts receivable as a percentage of sales and its collection period are about onethird as large as those of Hartmarx. At least four interpretations are possible:

OB is doing much better than Hartmarx in quickly collecting its receivables and minimizing its investment in this asset;
OB’s sales pattern during the year differs markedly from that of Hartmarx (that is,OB makes substantially fewer sales at year-end than Hartmarx does);
OB is inducing its customers to pay quickly either through strong pressure or steep discounts; or
OB factors more accounts receivable than does Hartmarx.

Figure 5.6 - Comparisons of Accounts Receivable Ratios

Also note that food stores have a much shorter collection period than apparel manufacturers, which is due to the nature of food stores’ credit sales. Most credit sales are made via customers’ credit cards at major banks and food stores are able to collect these receivables from the banks very quickly. Some credit sales are made to businesses (such as restaurants and caterers), but these customers pay by check within a reasonable period of time.

Case Study 5.1 summarizes an accounts receivable issue that arose for Topps Co., Inc., the sports card producer.

Case Study 5.1

Topps Co., Inc., produces sports cards. During two consecutive quarters, Topps’ accounts receivable increased by more than 50%, while sales declined. Such a trend might indicate that Topps is experiencing difficulty collecting from its customers. Topps asserts, however, that receivables have increased because of a change in its shipping schedule. It has begun to ship 50% of its cards in the final few weeks of a quarter. Thus, many of its accounts receivable are outstanding at quarter’s end, and at the same time, are not yet past due.

Required

a. Does Topps’ explanation make sense?
b. Can Topps’ claim be verified with publicly available information?

Solution

a. Topps’ explanation may well make sense. Because sales and accounts receivable are recorded when goods are shipped, making shipments closer to a quarter’s close increases the accounts receivable balance on the balance sheet date. Topps’ explanation, however, raises the question of why its shipping schedule has changed. Some firms who have difficulty meeting sales expectations pressure customers to place orders toward the end of a quarter.

b. Verifying Topps’ claim would be difficult. Firms do not publish shipping schedules or any other information that might indicate when shipments occurred during a quarter. Perhaps the best source of information is Topps’ customers. They would certainly know if shipping schedules have changed and the reason for any change.

Adequacy of Allowance for Uncollectible Accounts - Recall that writing off a specific account as uncollectible has no effect on total assets or net income. Assets and income are affected by the year-end adjustment in which uncollectible accounts are estimated. A great deal of judgment and discretion is used by management in making this estimate. Accordingly, analysts must carefully assess the reasonableness of the allowance for uncollectible accounts.

Few firms disclose their uncollectible accounts expense, yet most firms do disclose the year-end balance in the allowance for uncollectible accounts. The adequacy of this balance is usually assessed relative to the year-end accounts receivable balance. This is done by dividing the allowance by gross accounts receivable:

The reason for such a decrease is not entirely apparent. Perhaps OB made a conscious decision to decrease its sales to customers with dubious credit ratings. Such a change in the customer base would allow a decrease in the allowance for uncollectible accounts. Alternatively, recall from Chapter “The Income Statement,” that in 1997 OB ceased its European operations and terminated its relationship with certain domestic distributors. These changes altered the composition of OB’s customer base and might justify the decline in the allowance for uncollectible accounts.

Figure 5.5 shows that OB’s uncollectible accounts estimate is much more conservative than that of its competitor Hartmarx. Most analysts view conservative accounting practices with favor and feel that they result in earnings numbers of high quality.

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