Balance sheet: Receivables 3 comments

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One of the commonly mentioned warning signs that a company might not be doing as well as its profits suggest are a surge in receivables. This is often seen as a deterioration in asset quality of the company.

There is some basis in this pessimistic view about high and rising receivables. There have been well-known cases of "channel-stuffing" by companies, a practice which refers to pushing the company's goods to distributors and retailers, and immediately booking it onto the accounts as revenue, albeit in the form of receivables (it has to be, since the goods have not yet been converted into cash ie. sold to customers, by the retailers). Inevitably, much of these receivables turn bad, as the retailers cannot sell the goods. Lucent was one such classic example engaging in such aggressive business practices during the dot-com boom.

However, not all cases of surging receivables are necessarily ominous. I think there are a few factors to consider:
1)The relation to revenue growth
2)The nature of the company and its customers
3)The time frame involved

Factor 1 is probably quite clear to investors. If the revenue is growing, rising receivables is a natural thing, since customer credit will increase as they purchase more units of the company's products, given that similar credit policies are adhered to. The danger sign is when the receivables is growing disproportionately in relation ro revenue growth, say double the rate. This would suggest that the company has problems collecting debt from its customers or might have been over-aggressive in billing with a possibility that discounts on receivables might have to be given later.

Factor 2 has much to do with the quality of the receivables. If the company's customers are blue-chip companies one might not need to be overly concerned with high receivables, since there is little likelihood that these companies are going to renege on their payments (provided they were billed properly). That is why I am generally not that worried about high receivables in EMS (electronics manufacturing services) firms contract manufacturing for firms like Hewlett-Packard or Motorola. On the other hand, I am more worried about high receivables for distributors and retailers, as their customers are small businesses and mass consumers whose credit quality is generally poorer. In a downturn, these customers might be hit hard and the receivables might turn to bad debt. That is why I check the receivables really hard (as well as the customer base) before I buy such companies (such as electronics components distributors).

Factor 3 has to do with the time-frame in which the high receivables are occuring. For some companies, high receivables is a seasonal phenomenon; this often occurs hand-in-hand with seasonality of revenues. One example I can recall is Pacific Andes, which often has high receivables in one of its quarters (can't remember which) which is alleviated by the end of its financial year. It is more relevant to compare receivables year-on-year rather than quarter-on-quarter.

Generally, all things being said, it is always preferable to see assets in the form of cash rather than receivables on the balance sheet. That is when the transaction is fully complete; the customer has accepted the goods/services, and has effected full payment for them. Again the cliche: cash is king.