Accounts Receivable (AR)
Candlefocus EditorWhen a buyer purchases a good or service on credit, it creates an accounts receivable that is recorded on a company’s balance sheet as an asset. The customer then typically has a certain amount of time to pay the company back, usually 30-90 days. Accounts receivable is not always cash-based; in some cases, the receivable could take the form of a promissory note or other type of negotiable instrument.
The strength of a company’s AR portfolio can give an indication of how well the company is collecting payments. Analysts can use the accounts receivable turnover ratio or days sales outstanding (DSO) to measure a company’s AR portfolio strength. The DSO is calculated by dividing the average AR balance for the period by the total credit sales for the period, then multiplying this number by the number of days in the period, typically 365. The result is the average collection period.
The accounts receivable turnover ratio helps to determine when the money will be received and how quickly it is being collected from customers. This can help anticipate cash flow and more accurately forecast when a company will receive the money in its AR portfolio. A company with a higher AR turnover ratio can typically anticipate and receive funds sooner than a company with a lower AR turnover ratio.
Analysts also focus on any sudden changes in the accounts receivable portfolio. For example, if an AR portfolio is consistently increasing, it may be indicative of a problem with a customer’s ability to pay. This could lead to bad debt, which is expensive for the company to recover and can have a negative impact on profitability.
Overall, accounts receivable are an important component of a company’s balance sheet that can reveal the health of its short-term cash flow. Analysts use the accounts receivable turnover ratio to have an understanding of when the money will be received and how quickly accounts are being collected. A high turnover ratio is commensurate with well-managed accounts receivable and may signal a higher chance of anticipated cash flows.