6.4: Cash and Receivables- Analysis
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)The most common analytical tool regarding cash is the statement of cash flows. This statement reveals how a company spends its money (cash outflows) and where the money comes from (cash inflows). It is well known that a company's profitability, as shown by its net income, is an important performance evaluator. Although accrual accounting provides a basis for matching revenues and expenses, this system does not actually reflect the amount of cash that the company has received from its profits. This can be a crucial distinction as discussed earlier in this chapter. The statement of cash flows was discussed in Chapter 4.
For receivables analysis, three key financial tools are:
- An accounts receivable aging report
- Trendline analysis
- Ratio analysis
Accounts Receivable Aging Report
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 available in any accounting software package. As was discussed earlier in this chapter, this report divides the age of the accounts receivable into various groups according to the amount of time uncollected. Any invoices uncollected for greater than 30 days are cause for increased vigilance, especially if they drop into the oldest time grouping.
There are several issues to be aware of when analyzing accounts receivables based on an aging report.
Individual credit terms—Management may have authorized unusually long credit terms to specific customers, or for specific types of 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, most of the invoices are billed at the end of the month. If an aging report is run a few days later as part of the month-end analysis, 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 a few days ago. 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 grouping size—The groupings should approximate the duration regarding the company's credit terms. For example, if credit terms are just ten days and the first time grouping spans 30 days, nearly all invoices will appear to be current.
Trendline Analysis
Another accounts receivable analysis tool is the trendline. If the outstanding accounts receivable balance at the end of each month for the past year is graphed, it can be used 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.
Trendline analysis is also useful for comparing the percentage of bad debts to sales over time. If there is a strong recurring trend in this percentage, management will likely take action. As was discussed earlier, if the percentage of bad debt is increasing, management will likely authorize tighter credit terms to customers. Conversely, if the bad debt percentage is extremely low, management may elect to loosen credit terms to expand sales to somewhat more risky customers. Their philosophy will be that not all customers in the riskier categories will default on paying their debts to suppliers so there should be a net benefit from increasing sales. The bottom line is that the credit terms need to strike a balance between the two opposites. Trendline analysis 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 possible bankruptcy of a customer.
There are two issues to be aware of when you use trendline analysis:
- Change in credit policy. If management has authorized a change in the credit policy, it 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, it may cause profound changes in the trend of accounts receivable.
An interesting analysis related to accounts receivable is a trendline 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.
Ratio Analysis
A third type of accounts receivable analysis is ratio analysis. Ratios, on their own, do not really tell the whole story. Ratios compared to a benchmark, such as an industry sector or previous period trends will be more meaningful. Some of the more common ratios that include cash and accounts receivable are:
- Quick or acid-test ratio, which measures immediate debt-paying ability
- Accounts receivable turnover, which measures how quickly the receivables are converted into cash
- Days' sales uncollected, which measures the number of days that receivables remain uncollected
These are examples of liquidity ratios which measure a company's ability to pay its debts as they come due. Below is selected financial data for Best Coffee and Donuts:
| Best Coffee and Donuts Inc. | ||||||
|---|---|---|---|---|---|---|
| Excerpts from the Consolidated Balance sheet | ||||||
| (in thousands of Canadian dollars) | ||||||
| (Unaudited) | ||||||
| As at | ||||||
| December 29, | December 30, | |||||
| 2021 | 2020 | |||||
| Current assets | ||||||
| Cash and cash equivalents | $ | 50,414 | $ | 120,139 | ||
| Restricted cash and cash equivalents | 155,006 | 150,574 | ||||
| Accounts receivable, net (includes royalties | ||||||
| and franchise fees receivable) | 210,664 | 171,605 | ||||
| Notes receivable, net | 4,631 | 7,531 | ||||
| Deferred income taxes | 10,165 | 7,142 | ||||
| Inventories and other, net | 104,326 | 107,000 | ||||
| Advertising fund restricted assets | 39,783 | 45,337 | ||||
| Total current assets | $ | 574,989 | $ | 609,328 | ||
| Current liabilities | ||||||
| Accounts payable | $ | 204,514 | $ | 169,762 | ||
| Accrued liabilities | 274,008 | 227,739 | ||||
| Deferred income taxes | - | 197 | ||||
| Advertising fund liabilities | 59,912 | 44,893 | ||||
| Short-term borrowings | 30,000 | - | ||||
| Current portion of long-term obligations | 17,782 | 20,781 | ||||
| Total current liabilities | $ | 586,216 | $ | 463,372 | ||
| Best Coffee and Donuts Inc. | ||||||
|---|---|---|---|---|---|---|
| Excerpts from the Consolidated Statement of Operations | ||||||
| (in thousands of Canadian dollars, except share and per share data) | ||||||
| (Unaudited) | ||||||
| Year ended | ||||||
| December 29, | December 30, | |||||
| 2021 | 2020 | |||||
| REVENUES | ||||||
| Sales | $ | 2,265,884 | $ | 2,225,659 | ||
| Franchise revenues | ||||||
| Rents and royalties | 821,221 | 780,992 | ||||
| Franchise fees | 168,428 | 113,853 | ||||
| 989,649 | 894,845 | |||||
| TOTAL REVENUES | $ | 3,255,533 | $ | 3,120,504 | ||
Quick ratio
The quick or acid-test ratio, measures only the most liquid current assets available to cover its current liabilities. The quick ratio is more conservative than the current ratio which includes all current assets and current liabilities because it excludes inventory and any other current assets that are not highly liquid.
Formula:
Calculation:
| 2021 | 2020 | |
| Quick Ratio = | \(\frac{\$ 50,414+\$ 210,664+\$ 4,631}{\$ 586,216}=.45\) | \(\frac{\$ 120,139+\$ 171,605+\$ 7,531}{\$ 463,372}=.65\) |
As of December 31, 2021, with amounts expressed in thousands, Best Coffee and Donuts' quick current assets amounted to $265,709, while current liabilities amounted to $586,216. The resulting ratio produced is .45. This means that there is $.45 of the most liquid current assets available for each $1.00 of current liabilities. If a quick ratio of greater than $1.00 is a reasonable measure of liquidity, this means that Best Coffee and Donuts' ability to cover its current liabilities as they mature is at risk. Moreover, this ratio has weakened compared to the previous year of .65 or $.65 for each $1.00 in current liabilities.
Variations
In practice, some presentations of the quick ratio calculate quick assets (the formula's numerator) as simply the total current assets minus the inventory account. This is quicker and easier to calculate. By excluding a relatively less-liquid account such as inventory, it is thought that the remaining current assets will be of the more-liquid variety.
Using Best Coffee and Donuts as an example, for 2021, the quick ratio using the shorter calculation would be:
It is clear from the comparative calculations that .80 is significantly higher than the previously calculated .45 ratio. Restricted cash, prepaid expenses, and deferred income taxes do not pass the test of truly liquid assets. Thus, using the shorter calculation artificially overstates Best Coffee and Donuts more-liquid current assets and inflates its quick ratio. For this reason, it is not advisable to rely on this abbreviated version of the quick ratio.
Another type of analysis is to compare the quick ratio with its corresponding current ratio. If the current ratio is significantly higher, it is a clear indication that the company's current assets are dependent on inventory and other "less than liquid" current assets, such as legally restricted cash balances.
Even though the quick ratio is a more conservative measure of liquidity than the current ratio, they both share the same problems regarding the time it takes to convert accounts receivables to cash in that they assume a liquidation of accounts receivable as the basis for measuring liquidity. In truth, a company must focus on the time it takes to convert its working capital assets to cash—that is the true measure of liquidity. This is the credit-to-cash cycle emphasized throughout this chapter. So, if a company's accounts receivable, has a much longer conversion time than a typical credit policy of thirty days, the quickness attribute of this ratio becomes a focal point. For this reason, investors and creditors need to be aware that relying solely on the current and quick ratios as indicators of a company's liquidity can be misleading. The "quickness" attribute will be discussed next.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures the number of times per year on average that it takes to collect a company's receivables. When using this ratio for analysis, the following issues must be considered:
- Credit sales, rather than all sales, would be the better measure to use for the numerator, but this information can be more difficult to obtain by third parties such as prospective investors and creditors, so total sales are often used in practice.
- Typically, average receivables outstanding are usually calculated from the beginning and ending balances. However, if a business has significant seasonal cycles, calculating a series of turnover averages throughout the fiscal year, such as semi-annually or quarterly, will likely provide better results.
- Companies can choose to sell their receivables making comparability with other companies not suitable.
- Net accounts receivable includes the allowance for doubtful accounts (AFDA), so the choice of what method and rates to use when estimating uncollectible accounts can vary significantly between companies, resulting in invalid comparisons.
The key consideration is to ensure comparability and consistency when interpreting ratio analysis, since ratios are used to determine favourable or unfavourable trends resulting from comparison to other factors. Using Best Coffee and Donuts data, we calculate the following:
Formula:
Calculation for 2021:
| \(=\frac{\$ 3,255,533}{(\$ 210,664+171,605) \div 2}\) | |
| \(=17.03\) times or every 21.43 days on average \((365 / 17.03=21.43)\) |
If the industry standard or the company credit policy is n/30 days, an accounts receivable turnover of every twenty-one days on average would be a favourable outcome compared to the thirty-day due date set by the company's credit policy. Aging schedules would provide further information about the quality of specific receivables and would highlight any customer accounts that were overdue and requiring immediate attention.
Days' sales uncollected
This ratio estimates how many days it takes to collect on the current receivables outstanding.
Formula:
Days' sales uncollected \(=\left(\frac{\text { Accounts receivable (net) }}{\text { Net sales }}\right) \times 365\)
Calculation for 2021:
Days' sales uncollected \(=\left(\frac{\$ 210,664}{\$ 3,255,533}\right) \times 365=23.62\) days
Note that the average receivables are not used in this calculation. This means that the ratio measures the collectability of the current accounts receivables instead of the average accounts receivable. If a guideline for this ratio is that it should not exceed 1.33 times its credit period when no discount is offered (or the discount period if a discount is offered), 23.62 days compared to the benchmark of forty days () means that the ratio is favourable.
The best way to analyze accounts receivable is to use all three techniques. The accounts receivable collection period can be used 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 add trend analysis to see if these problems have been changing over time.