February 9, 2017

Why are receivables up more than sales?

“Always take a company seriously, even if its financials are knee-slapping, hoot-promoting drivel”

I’m about halfway through The Art of Short Selling. It has some incredible short selling case studies. One accounting issue that comes up is where accounts receivables spikes without a proportionate increase in actual cash sales. Tracking the ratio between accounts receivable and sales is a way to track a pretty simple trick that company accountants can pull. The example used is that of the a corporate/government training company with a famous politician on the board. It ended badly for shareholders. This happens a lot in questionable companies getting “out over their skis.”

Anyways…

“Receivables can be up by more than sales for several reasons:
1. The company acquired a company, and the acquisition is not yet under control-collections do not have the same billing cycle or terms for sales, for example. If the acquisition was a large one relative to sales, the relationship of year versus year in receivables is not comparable.

2. The company is booking revenues too aggressively-for example, a three-year contract recognized at the front end, so that receivables stay high because the rate of payment is slow.

3. The company changed its credit policy to easier terms or is giving incentives for sales, thereby jeopardizing future sales.

4. The company is having trouble collecting from customers. Building accounts receivables is a cost to the company because investing in business already booked hurts cash flow. Timely collections are sensible in a growing business because growth eats money by definition.”

…

How companies book revenues is a particularly quarrelsome issue for analysts: There are many ways to fool around, and technology and training companies are two categories of regular abusers. Revenues booked should have a consistent relationship with collection-if a company ships now and collects in 60 days, the accounts receivable schedule should consistently mirror that policy. So rising receivables versus sales or a lengthening number of days in receivables should always trigger a question: Something has changed, it says.

If your screener sets of an alarm due to a spike in receivables relative to sales, running through this list might help you find the answer. Understanding this question gets back to the basic question: how does this company make(or fail to make) money?

One more quote to top it off:

“For the last week I’ve been carrying “The Art of Short Selling” around with me just about everywhere. Every time I get a break, I just open to a chapter. Doesn’t matter if I’ve already read it. I just read it again.”

Michael Burry(1999)