Getting an Allowance
The end of benefitting from a post-Covid normalization of bad debts
One of the classic earnings quality red flags that most analysts are familiar with is a decline in the allowance for bad debts. When a company generates receivables at the time of sale, it must estimate what percentage of those receivables will go uncollected based on past experience and its assessment of the current macro environment. Underestimating this percentage will result in higher earnings in the period, but results in future periods will be penalized when those inadequately reserved receivables are not collected, and the company must take additional charges to the reserve.
Covid created a unique situation in which the sudden uncertainty of the outlook forced companies to quickly ramp up their allowances to reflect the increase in the likelihood of customer default. When conditions began to normalize, the reserve percentages began to return to normal- some faster than others. However, as conditions began to return to normal over the last couple of years, many companies were able to reserve less against current revenue and essentially let the higher-than-normal reserves work their way back through profits. This has provided a meaningful, non-operational boost to the earnings of some companies. For some, they have even taken reserves percentages below their pre-Covid levels. For these firms, not only will the tailwind cease, but it will turn into a meaningful headwind when they must begin rebuilding the reserve percentage to a sustainable level.
We will examine a few companies below where bad debt allowances are foreshadowing such a shift in the wind.
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