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How To Evaluate The Accounts Receivable

The accounts receivable (or trade debtors) figure that we see in a balance sheet is a key piece of information for lending bankers. If the business sells its products or services on credit terms to its customers, this is the future cash flow which, of course, will be the source of debt repayment.

The two key questions

When we look at a business’ accounts receivable there are two key questions that we have to ask;

  1. “What does the structure of the accounts receivable list tell us about the business’ operations”
  2. “How quickly will the outstanding amounts be collected by the business from its customers and so be converted into cash?”

Get the details

Just looking at the total accounts receivable figure will not answer the two key questions. We have to ask for a breakdown of the figure which business’ will usually have available in the form of a list. The list should at least tell us who the customers are that owe money to the business, for how long the amounts have been owed and how much is owed by each customer.

What’s the process?

When we receive a list of accounts receivable from clients, what is the process to analyse the list?  Much depends on why we want the information. If we merely want to understand the future cash flow, then we will follow the process outlined below.

But if we intend to use the accounts receivable as collateral, then we have to first remove any names that are going to be difficult for us collect in the short-term or in the event of a liquidation. That will include;

  • amounts owing by foreign customers
  • amounts owing by inter-company or intra-group debtors
  • amounts outstanding over 90 days (take care though if the normal terms offered to customers by the business is close to this period)

The three questions to ask about the accounts receivable

What is the spread of accounts receivable, i.e. how many customers are there?  Too few names can mean that the overall list is concentrated in a small number of customers and if one of them fails, our client may have a cash flow problem as a result.  On the other hand, too many names could make it almost impossible for us to collect should we be forced to do so.

What is the the age-analysis of the list, i.e. how long are customers taking to pay? If the list is very current (customers pay very quickly – either because they can get a discount from our client by doing so, or because our client extends very short credit terms) it is of little value as collateral for our facilities. 

The reason for this is that we are usually one of the last to know that our client has a problem and, if we have to collect the accounts receivable as is our legal right to get repayment of our facilities, the likelihood is that the customers will have already paid our client in the normal course of business.

This is why we apply a relatively small advance value to an accounts receivable figure for collateral purposes.  Conversely, customers taking too long to pay our client may indicate that they may have cash flow problems themselves or that our client is too slow in collecting amounts owing to it.

What is the quality of the names in the list, i.e. are there names that we know are potential bad debts and who will never pay?  Also, are there perennial slow payers in the list that will affect our client’s cash flow, e.g. government, large corporates etc?

So, a proper analysis of the accounts receivable will help us to build a better picture of the business’ operation as well as understand the available future cash flow that will repay our debt.

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