The Balance Sheet : Accounts Receivable
September 7, 2007
On December 31, 2003, Houston Sash & Door was owed $230,962 by its customers (net of reserve). The company generated these receivables by making sales on credit. As soon as a sale was made, a receivable was entered in the company’s accounts receivable ledger. The $230,962 figure represents the total amount of credit sales that hadn’t yet been paid on December 31, 2003. Does this mean that within the coming year the business can expect to receive exactly $230,962 from its customers? Not quite. Every business has a certain percentage of accounts receivable that go bad.
The debtors go out of business, skip town, or go into bankruptcy, and the receivable has to be written off. Not only does every business have bad debts, but many businesses can predict fairly accurately the percentage of receivables that will go bad. That’s what the reserve for doubtful accounts is for. It anticipates and deducts all the accounts that experience has proven will turn out to be uncollectible. The issue for a prospective buyer is whether the allowance for doubtful accounts is adequate. If it isn’t, the accounts receivable account will be overstated, as will the resulting total net worth of the business. How can you tell if an adequate allowance for bad debts had been made? Have your accountant compare the amount reserved with the actual bad debts for prior years.
Let’s return to Houston Sash & Door’s balance sheet. It shows $230,962 in accounts receivable on December 31, 2003, up from $139,917 on December 31, 2002, a 65 percent increase in one year! How can we account for this? It may simply be that business was great in 2003, resulting in an increase in accounts receivable. But it may also be the result of Houston extending credit in 2003 to customers who wouldn’t have received credit in 2002. He might have done that to prettify the books in anticipation of the sale of the business. By selling to customers to whom he wouldn’t have in the past, not only do the total current assets increase, the sales revenue account on the income statement also increases. We’ll see shortly, when we discuss the ratios we pull from the financials, that there’s a surefire way to see whether accounts receivable have been artificially pumped up. For now, you should note that savvy lenders and brokers often request that an aging report accompany the balance sheet. The aging report is a breakdown of the accounts receivable by the length of time they’ve been outstanding. If a large percentage of Houston Sash & Door’s $230,962 are less than 30 days overdue, there shouldn’t be a problem. But if a large percentage of the receivables are more than 90 days overdue, there may be a real problem lurking. It may also mean that Houston has become a little lax in collecting the receivables, knowing he’s about to retire. Worst of all, the jump in receivables may be the result of Houston having shipped out some inferior products (again, in order to prettify the books) and the buyers are refusing to pay. If this is the case, and the buyers who are balking are large or long-standing customers, you may really have a problem on your hands. After the sale, uncollectible receivables aren’t Houston’s problem; they’re yours.
A final word on accounts receivable: Every so often you’ll find that the receivables that result from a business’s credit sales aren’t an asset of the business at all. This occurs when a business factors its accounts receivable; that is, a business sells its receivables to a factor for cash on a discounted basis. The debtors are then notified they are no longer obligated to pay the debt to the business; they’re obligated to pay the factor. At first blush, it may seem that a business must be desperate if it sells its receivables at a discount just to get some immediate cash. Not necessarily. Factoring of accounts receivable is fairly common in certain businesses. Manufacturers prefer the assured income stream that dealing with factors affords them, rather than dealing with scores of customers. If you’re dealing with a business whose receivables have been factored, you should check the arrangement with the factor very carefully. Factors buy receivables in two ways: without recourse, or with recourse. If the factoring is without recourse, the factor suffers the loss if the receivable proves uncollectible. If the factoring is with recourse, the business still owes the factor if the factor can’t collect; the factor is acting as little more than a bank lending money secured by receivables.
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