How should investors interpret accounts receivable information on a company's balance sheet?

how a balance sheet works

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.

On a company's balance sheet, the accounts receivable line represents money it is owed by its customers for goods or services rendered. 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. At the point of sale, the accounting is as follows: XYZ Company records the $500,000 as a receivable by debiting its accounts receivable account. Because the money is classified as revenue to the company the moment the sale is made, rather than when the cash is actually received, a $500,000 credit is also made to the revenue account on the balance sheet, which balances the entry. When the customer pays, hopefully within the 90 days allotted, XYZ Company reclassifies the $500,000 as cash on its balance sheet by debiting the cash account and crediting the accounts receivable account.

Accounts receivables, like cash, are considered 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. Ideally, when a company has high levels of receivables, it signifies that it will be flush with cash at a defined date in the future.

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 customer ABC went bankrupt after its purchase from XYZ Company before paying the bill, or that it found itself insolvent. 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 .

Investing basics dictate conducting further research into a company's accounts receivables. 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 a concern, as this sometimes means that the company's finance department isn't competitive with its terms.

Another balance sheet account to analyze closely is allowance for doubtful accounts. A sharp increase in this account is a likely indicator that the company is issuing credit to riskier customers; take this information into consideration when analyzing the company's receivables. Look at the company's accounts receivable turnover, 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 on its receivables.

Source: www.investopedia.com

Category: Forex

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