Accounts receivable analysis

Overview of Accounts Receivable

Accounts receivable are the amounts owed to a business by its customers, and are comprised of a potentially large number of invoiced amounts. Accounts receivable constitute the primary source of incoming cash flow for most businesses, so you should analyze these invoices in aggregate to ascertain the health of the underlying cash flows. Several accounts receivable analysis techniques are noted below.

Accounts Receivable Analysis

One of the easiest methods for analyzing the state of a company's accounts receivable is to print an accounts receivable aging report, which is a standard report in any accounting software package. This report divides the age of the accounts receivable into various buckets, which you can sometimes alter within the accounting software to match your billing terms. The most common time buckets are from 0-30 days old, 31-60 days old, 61-90 days old, and older than 90 days. Any invoices falling into the time buckets representing periods greater than 30 days are cause for an increasing sense of alarm, especially if they drop into the oldest time bucket. There are several issues to be aware of when you analyze based on an aging report, which are:

  • Individual credit terms. Management may have authorized unusually long credit terms to specific customers, or perhaps only for particular invoices. If so, these items may appear to be severely overdue for payment when they are, in fact, not yet due for payment at all.

  • Distance from billing date. In many companies, the majority of all invoices are billed at the end of the month. If you run the aging report a few days later, it will likely still show outstanding accounts receivable from one month ago for which payment is about to arrive, as well as the full amount of all the receivables that were just billed. In total, it appears that receivables are in a bad state. However, if you were to run the report just prior to the month-end billing activities, there would be far fewer accounts receivable in the report, and there may appear to be very little cash coming from uncollected receivables.

  • Time bucket size. You should approximately match the duration of the time buckets in the report to the company's credit terms. For example, if credit terms are just ten days and the first time bucket spans 30 days, nearly all invoices will appear to be current.

  • Unapplied credits. There may be unapplied credits on the report. If so, clean up the report by researching which invoices they should have been applied against. Doing so may reduce the amount of overdue receivables listed on the report.

Another accounts receivable analysis tool is the trend line. You can plot the outstanding accounts receivable balance at the end of each month for the past year, and use it to predict the amount of receivables that should be outstanding in the near future. This is a particularly valuable tool when sales are seasonal, since you can apply seasonal variability to estimates of future sales levels.

Trend analysis is also useful for comparing the percentage of bad debts to sales over a period of time. If there is a strong recurring trend in this percentage, management may want to take action. For example, if the percentage of bad debt is increasing, management may want to authorize tighter credit terms to customers. Conversely, if the bad debt percentage is extremely low, management may elect to loosen credit in order to expand sales to somewhat more risky customers. This is a particularly useful tool when you run the bad debt percentage analysis for individual customers, since it can spotlight problems that may indicate the imminent bankruptcy of a customer.

There are several issues to be aware of when you use trend line analysis, which are:

  • Change in credit policy. If management has authorized a change in the credit policy, this can lead to sudden changes in accounts receivable or bad debt levels.

  • Change in products or business lines. If a company adds to or deletes from its mix of products or business lines, this may cause profound changes in the trend of accounts receivable.

  • Change in business conditions. If the economy is in decline, there may be an increasing trend of bad debts that is well above the historical average.

A third type of accounts receivable analysis is ratio analysis. The most commonly used ratio is the accounts receivable collection period, which reveals the number of days that an average customer invoice remains outstanding before it is paid. The formula is:

Average accounts receivable ÷ (Annual sales ÷ 365 Days)

For example, if there are usually $500,000 of accounts receivable outstanding at any time, and annual sales are $3.65 million, then the accounts receivable collection period is calculated as:

$500,000 Accounts receivable ÷ ($3,650,000 Annual sales ÷ 365 Days)
= 50 Days collection period

In the example, we cannot tell if a 50-day collection period is good or bad, since we do not know the duration of the credit terms.

In summary, the best way to analyze accounts receivable is to use all three techniques noted here. You can use the accounts receivable collection period to get a general idea of the ability of a company to collect its accounts receivable, add an analysis of the aging report to determine exactly which invoices are causing collection problems, and then add trend analysis to see if these problems have been changing over time.

Other Types of Analysis

An interesting analysis related to accounts receivable is a trend line of the proportion of customer sales that are paid at the time of sale, noting the payment type used. Changes in a company's selling procedures and policies may shift sales toward or away from up-front payments, which therefore has an impact on the amount and characteristics of accounts receivable.

Related Courses

Business Ratios Guidebook 
Credit and Collection Guidebook 
The Interpretation of Financial Statements