Educate Yourself - Cash In Those Receivables

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Cash In Those Receivables
by Charles B. Carlson, CFA
Dow Theory Forecasts

Ask any business owner what are the three most important ingredients for a successful venture, and I guarantee you one of the three will be having customers who pay their bills on time.

Indeed, for many companies, sales are not a problem. Getting customers to pay for the stuff, however, can be a huge problem. In fact, a big cause of extinction among small businesses, in particular, is the inability to turn sales (in the form of accounts receivables) into cash in a timely fashion.

Whether a company is a small shop or a multibillion-dollar conglomerate, the lesson remains relevant - it's cash flow that ultimately matters. You can have all the sales you want. But if you can't turn sales into cash, forget about it. Without cash, you can't pay overhead. You can't pay salaries. You can't pay suppliers. Without cash, a company ultimately can't survive.

Fortunately, any investor can analyze how well a company turns receivables into cash by examining a company's receivables turnover ratio.

To compute a firm's annual receivables turnover, divide net annual sales by average account receivables (average receivables is the beginning period receivables plus the ending period receivables divided by two). Receivable numbers are found on the firm's balance sheet, under assets. The result shows how many times a company turns over its receivables in the course of a year. To turn receivables turnover into the average collection period, simply divide 365 by the receivables turnover.

For example, a company that turns over its receivables nine times a year has an average collection period of 40 days (365 divided by 9). I like to use collection period - also known as days receivable - because this is a more intuitive number for comparison purposes. These numbers are all available in the company's 10-Q and 10-K financial reports, which may be obtained from the company or at the SEC's Web site - www.sec.gov.

Now I realize that every company where receivables turnover is declining (and, thus, the average collection period is increasing) is not a company destined for Chapter 11. Nevertheless, lengthening collection periods could signal several underlying problems:

Lax or overly generous credit policies (a company may relax credit policies in order to gain business).
Receivables write-offs.

Wall Street is not a fan of either of these developments and usually severely penalizes companies with collection problems. Thus, tracking a company's receivables turnover may provide the type of early warning sign that allows you to head for the exit ahead of the sellers.

Remember - receivables don't pay the bills. Cash does. That's why it's crucial to know how well the companies you own turn receivables into dollars.

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