Accounts Receivable: The Money That’s Technically Yours (But Not in Your Bank Yet)
Let’s talk about something that might not sound all that exciting at first—accounts receivable. But don’t hit that “back” button just yet. While accounts receivable (AR) might not have the glitz and glamour of the latest tech stock or a blowout earnings report, it’s actually a very important number to understand, especially if you’re an investor who likes to dig beneath the surface.
In plain terms, accounts receivable represents the money a company is owed by its customers for goods or services delivered but not yet paid for. It’s essentially a company’s IOUs—the unpaid bills from customers that will (hopefully) turn into cash soon. But the real question is: how soon? And is that money actually coming in?
Let’s break it down and see why you should care about AR when making your next investment decision.
What Is Accounts Receivable?
At its core, accounts receivable is an asset. It’s the money a company expects to collect in the future from customers who bought goods or services on credit. If you’re imagining a pile of invoices sitting on someone’s desk, you’re not too far off. It’s that stack of customer debts, sitting there like a stack of bills waiting to be paid.
How Does Accounts Receivable Impact Investors?
Now, you’re probably wondering why this is relevant to you as an investor. Well, accounts receivable can reveal quite a bit about a company’s cash flow, liquidity, and financial health. And, as you know, cash flow is the lifeblood of any business. Let’s break it down:
1. Cash Flow (or Lack Thereof)
Imagine you’re looking at a company, and its accounts receivable balance is growing fast. On the surface, that might look great! It means customers are buying more stuff, right? But hold your horses. If the company’s AR is growing but its cash flow is slowing, it could be a sign that customers aren’t paying their bills on time. The company may be making sales, but it’s not getting paid quickly, which can create a cash crunch.
If you’re an investor, you want to see a healthy balance between sales and collections. A big, growing AR balance could be a sign that the company is struggling to collect payment, which could be problematic if the business is relying on that cash to pay its own bills.
2. Liquidity and Financial Health
Liquidity is the ability to pay your short-term debts without selling off assets or borrowing more money. If a company has a huge AR balance but little actual cash in the bank, that might be a liquidity red flag. After all, while accounts receivable is an asset, it’s not cash—until those customers actually pay up.
As an investor, you want to know that a company has enough liquidity to meet its obligations without scrambling for cash. If AR is too high, it could indicate that the company is waiting on customers to pay, which could lead to short-term financial strain. You wouldn’t want to invest in a company that is constantly juggling payments, right?
3. Collection Efficiency and Risk
How quickly does the company convert its accounts receivable into cash? This is where the accounts receivable turnover ratio comes into play (don’t worry, we won’t get too technical here). A high turnover ratio means the company is efficient at collecting its debts—it’s turning its AR into cash quickly. A low turnover ratio, on the other hand, means that the company might be struggling with collections.
As an investor, you want to see efficiency in the company’s collections process. If AR is growing without a corresponding rise in cash flow, there’s a risk that the company is overestimating how much it will collect or relying too heavily on customers to pay up on time. This could be a sign of inefficiency or poor customer credit management.
4. Risk of Bad Debt
Here’s the kicker: not all accounts receivable will actually be collected. Some customers may not pay at all, leaving the company with bad debt. So, companies will often set aside a provision for doubtful accounts—a way of acknowledging that not every IOU will be fully paid.
When you’re looking at accounts receivable, you want to see if the company is being realistic about the likelihood of collecting on its outstanding invoices. A company that isn’t accounting for bad debt properly might be overestimating the health of its balance sheet. And that’s a problem if you’re an investor, because it means the company might not actually have the cash flow it claims.
5. Aging AR: The Telltale Sign
Here’s where it gets interesting (and potentially alarming). When you look at a company’s accounts receivable, it’s important to ask: How old is that AR? Companies often provide a breakdown of aging accounts receivable—how long each invoice has been outstanding. If the AR balance is getting old, it’s a bad sign. An invoice that’s been sitting for 90 days or more might be a sign that customers are delaying payment or having trouble paying. The longer the AR sits there, the more likely it is to turn into bad debt.
As an investor, you should keep an eye on the aging of accounts receivable—if the company’s AR is old, it could signal that they’re relying on customers to pay up without much success. This could hurt cash flow and increase the risk of bad debt. If the company’s AR is consistently aging poorly, it might be time to question how well they’re managing customer credit and collections.
Real-World Example: WidgetCo’s AR Woes
Let’s say you’re looking at WidgetCo, a company that’s been growing rapidly, with increasing sales every quarter. You look at their accounts receivable, and you notice something worrying: it’s growing even faster than their sales. In fact, the AR balance is rising at an alarming rate, while their cash flow has been relatively flat.
Digging deeper, you discover that WidgetCo has been offering longer credit terms to attract more customers, which is great for sales growth but not so great for cash flow. Even worse, their AR turnover ratio is declining, and a significant portion of their AR is aging—with many invoices now sitting unpaid for over 90 days.
As an investor, you now face a tough decision: While WidgetCo is growing its sales, its ability to turn those sales into actual cash is questionable. The company might be facing liquidity issues or running the risk of writing off a chunk of its AR as bad debt. This could impact future profitability and ultimately affect the stock price.
Key Takeaways for Investors
- Accounts Receivable = Future Cash, If It Gets Collected: AR shows the money owed to a company, but that money doesn’t count as cash until it’s collected. Growing AR without growing cash flow could signal trouble.
- Aging AR = Bad Sign: If AR is getting older, it might indicate that customers are delaying payments. Old AR is often a precursor to bad debt—and you don’t want that on your balance sheet.
- Watch for AR Turnover: A high turnover ratio means a company is doing a good job of converting its AR into cash. A low turnover ratio? Might be time to look deeper.
- Provision for Doubtful Accounts: Always check if the company is accounting for bad debt realistically. A company that underestimates bad debt might be hiding potential cash flow problems.
- Cash Flow > Sales: Even if a company is increasing sales, it’s all about how quickly those sales turn into cash. If it’s taking too long to collect, it could hurt the company’s liquidity and ultimately affect your returns.
In the end, accounts receivable might not be the most exciting line item on a balance sheet, but it’s one that can give you significant insights into a company’s cash flow and financial health. So, next time you’re evaluating an investment, take a moment to dig into those AR numbers. They might just reveal whether the company is sitting on a pile of cash or waiting for customers to pay up. And as we all know—waiting on payments is no one’s idea of fun.