Investors should interpret accounts receivable information on a company’s balance sheet as money that the company has a reasonable assurance of being paid by its customers at a defined date in the future. However, there is no firm guarantee that a company will be paid the money it is owed.
If a company has high levels of receivables, it typically signifies that it will receive a high amount of cash in future, but that it is yet to do so.
AR on the Balance Sheet
On a company’s balance sheet, the accounts receivable line represents money the company is owed by its customers for goods or services rendered. On the balance sheet, money is classified as revenue to the company the moment a sale is made, rather than when the cash is actually received. A credit is simultaneously made to the revenue account on the balance sheet, which balances the entry. After receiving payment the company will reclassify the cash on its balance sheet by debiting the cash account and crediting the accounts receivable account.
An Example
Suppose XYZ Company agrees to sell $500,000 worth of its product to customer ABC on net 90 terms—meaning the customer has 90 days to pay. First, at the point of sale, XYZ Company records the $500,000 as a receivable by debiting its accounts receivable account. A $500,000 credit is also entered into the revenue account. When the customer pays, hopefully within the 90 days allotted, XYZ Company reclassifies the $500,000 as cash on its balance sheet. It will debit the cash account and credit the accounts receivable account.
Receivables as an Asset
Accounts receivables, like cash, are considered a current assets. An asset is something of value that a company owns or controls. Accounts receivables are considered valuable because they represent money that is contractually owed to a company by its customers. Low levels of receivables coupled with low sales growth rates are another cause for concern, as this sometimes means that the company’s finance department isn’t competitive with its terms.
Accounts receivables are not guaranteed to turn into cash. For various reasons, customers neglect to pay the money they owe at times. From the above example, suppose that the customer went bankrupt before paying the bill. Even though the customer has a legal obligation to pay, it cannot do so if it doesn’t have the money. Receivables that a company does not expect to collect, instead of being reclassified as cash, are moved to a contra-asset account on the balance sheet known as allowance for doubtful accounts.
Investment Worthy Levels of Accounts Receivable
Investing basics dictate conducting further research into a company’s accounts receivables shown on a balance sheet. Just because receivables are an asset doesn’t mean that high levels of them should uniformly be considered good.
When a company has high levels of receivables in relation to its cash on hand, this often indicates lax business practices in collecting its debt. Low levels of receivables are another cause for concern. Sometimes low levels of accounts receivable means that the company’s finance department isn’t competitive with its financing terms.
Another balance sheet account to analyze closely is the allowance for doubtful accounts. Doubtful accounts are those that the company might not receive full payment on. A sharp increase in this account is a likely indicator that the company is issuing credit to riskier customers.
Also, look at the company’s accounts receivable turnover. AR turnover is calculated by dividing its total sales on credit over a period of time by its average accounts receivable balance during that time. A high number here indicates that the company is effective at collecting its receivables from customers.