Bill and You Shall Receive- (Most of the Time)
Industrials benefitting from declining bad debt reserves
There are a handful of decent books that cover the basics of earnings quality analysis. A common thread among them seems to be that accounts receivable is the first area on which analysts should focus their attention during a forensic review of the financial statements. This is for good reason as aggressive revenue recognition can materially impact the bottom line. However, most instruction seldom gets past the basic principle that receivables rising faster than sales is a bad thing. Some earnings quality screening tools automatically dock a company’s score if receivables growth trips some pre-determined threshold as if being one notch below indicates no trouble at all and one notch above indicates outright malfeasance. We are firm believers that good analysis requires much more nuance, and that earnings quality analysis, much like investing itself, is as much art as it is science.
This report will address the points analysts should be considering when reviewing a company’s receivables-related disclosures. We will then discuss the results of our examination of the receivables of over 70 industrial companies which includes a more in-depth look at 10 companies that have seen their recent results materially impacted by unusual changes in receivables-related items.
DSOs Rising
We will start with the well-documented concept that receivables rising faster than sales over time is a red flag. The gold-standard measure used to capture the relationship between revenue and receivables is “days sales outstanding”, or DSO, which we calculate as ending accounts receivable multiplied by 91.25 days divided by quarterly revenue. Other variations include calculating this using annual data or choosing to average the beginning and ending receivables balances.
The DSO balance should generally be compared to the year-ago result to account for seasonality in billing. Any increase should be viewed with caution- but how big an increase is too much? Unfortunately, there is no easy answer. The real value is not added by calculating the ratio but rather in the interpretation of the trend in the ratio and the components that make it up. The following should be considered:
A jump in DSOs is not concerning if any of the following are true:
The company made an acquisition in the middle of a quarter which skewed the DSO upward as the full amount of acquired receivables were reflected in the ratio while only a few weeks of revenue were recorded.
The company acquired a business that operates with a higher or lower amount of receivables relative to sales than the company’s legacy business. This could result in an increase in DSO for the next 4 quarters or until the company can bring down the working capital requirements of the new business.
Revenue is growing very rapidly or is experiencing a sudden acceleration resulting in new receivables being generated that have not had time to be collected before the end of the period.
However, if none of these conditions exist, then an increase in DSO could be an indication of a less benign situation including:
The company was falling behind on its sales quota for the quarter and offered generous payment terms or other incentives to customers if they would commit to buying before the end of the quarter. This essentially pulls revenue from the next quarter into the current quarter. That may help the company make this quarter’s numbers but puts it in the position of starting the next quarter “in the hole.”
The company is experiencing a slowdown in collections which may be an indication of deteriorating macro conditions in its end markets. However, it may also be an indication that the company’s sales mix has shifted to larger, more powerful customers able to demand longer payment terms.
Being able to accurately determine which one of the above factors is driving the DSO change requires digging into press releases, conference call transcripts, and management discussion and analysis (MD&A) sections of SEC filings looking for answers. Once again we see ratios and screening don’t provide answers, they merely help identify the best places to dig.
Changes in Bad Debt Allowance
When a company books a receivable, it almost always records it net of an estimated allowance for amounts that will not be collected due to customer default. Almost all companies with large receivables balances report this allowance either on the balance sheet next to the receivables heading or in a footnote. Analysts should track the allowance as a percentage of gross receivables over time and start asking questions if this figure begins to decline, considering the following:
It is normal for a company to increase the allowance percentage during economic slowdowns. The 2008 financial crisis and Covid saw many companies take large charges to build their reserve levels to 2 or 3 times their normal levels.
As economic conditions normalize, a decline in the allowance percentage is to be expected. However, analysts should be alarmed by any sudden decline in the allowance percentage during stable financial conditions or if the allowance percentage falls below its long-term historical norm.
Keep in mind that some companies include reserves for estimated discounts and returns in the bad debt allowance and it is often difficult to tell which component is moving the account. This should be considered when comparing the absolute reserve percentage between companies.
Provision Expense and Write-Offs
When analyzing changes in the bad debt allowance, analysts should keep in mind that the account is moved up and down by factors including provision expense associated with newly booked receivables, collections of receivables, changes in estimates of the collectability of receivables already provided for, and write-offs of existing receivables. Unfortunately, many companies do not disclose provision expense and write-offs quarterly. Some record provision expense in the operating cash flow section of the cash flow statement while some may record both provision expense and write-offs in a separate footnote. If provided, this information can give much greater insight into the actual profit impact from movements in the reserve.
Analysts should track provision expense as a percentage of sales over time and take note of any unusual declines.
Often, a company may record a credit as opposed to an expense which indicates it is reversing previously booked allowances into earnings. Even if this is warranted by improving credit experience, it nonetheless represents a non-operating, unsustainable benefit to current profits. In some cases, management will point such an item out in its discussion of results. Unfortunately, this is not always the case, and any time such material benefits are not discussed while comparably-sized headwinds are highlighted or even added back to non-GAAP results, it should reduce management’s credibility in the mind of the analyst.
Receivables Factoring
Another receivables-related item that is often overlooked by investors is factoring arrangements under which the company sells accounts receivables to third-party financing companies. This allows the company to receive its cash more quickly. In most situations, the company maintains the responsibility to collect the receivables and remit the cash to the factoring company when it is collected. Under such arrangements, the receivables are removed from the company’s balance sheet even though they are still outstanding. This requires the analyst to add the amount of factored receivables that remain outstanding back to receivables left on the balance sheet to get a meaningful DSO calculation.
GAAP does not maintain uniform disclosure requirements related to receivables submitted to factoring programs. Any information provided can typically be found in the footnotes although it is occasionally disclosed separately on the balance sheet.
Analysts should consider the following when evaluating factoring arrangements:
The purpose of DSO analysis is to examine how rapidly receivables are being generated. Therefore, factored balances that have not been collected must be added back to receivables on the balance sheet or the DSO ratio will be understated.
When the company sells receivables, it is almost always booked as an operating cash flow. Thus, an acceleration in receivables factoring will provide a temporary boost to cash flow growth that must be taken into consideration when analyzing cash flow trends.
Below, we dig into the receivables details for ten industrial companies that displayed recent unusual movements in their allowance for bad debt accounts.
Let’s get Behind the Numbers…