Accounts Receivable, Payable and Inventory

It is crucial that a company effectively manages its accounts receivables, inventory positions, and accounts payables. If not, the company could find itself in a consistent loss-making position, which will place doubts on its ability to continue in business as a going concern.

Accounts Receivable Management

In managing its accounts receivable, a company is essentially taking steps to ensure that outstanding accounts receivable items can be easily converted into cash. Two popular measures for determining accounts receivable performance are: the accounts receivable aging schedule and the number of days of receivables.

Accounts receivable aging schedule

The accounts receivable aging schedule provides a breakdown of accounts receivables into categories of days outstanding. This can be used to derive a weighted average number of collection days. The smaller this number, the more effective a company is at managing its accounts receivables.

Number of days of receivables

The number of days of receivables gives us a broad picture of a company’s accounts receivable collection efforts. When compared with the company’s credit policy, it tells us how effective collection efforts are relative to the company’s credit-granting terms. It can also be used to determine the weighted average day’s sales outstanding which measures how long it takes to collect from customers irrespective of the sales level or change in sales. This, however, requires data on the number of days a company takes to collect accounts of each age grouping. This sort of information may not be available for other companies which makes a comparison with peer companies difficult.

Inventory Management

Inventory management requires a balancing act; having enough inventory to allow for reasonable sales to take place, but not too much which causes some to become obsolete.

The inventory turnover ratio and the number of days of inventory are two popular measures for evaluating a company’s inventory management. The inventory turnover ratio measures the number of times that inventory is sold or used in a time period, such as a year. It is easy to compute and compare with other standards and across time, and may have different results for companies within the same industry because of differences in their product mixes.

The number of days of inventory = 365/inventory turnover.

Accounts Payable Management

The number of days of payables or average age of payables is a common measure for evaluating the effectiveness of a company’s accounts payable management. It is usually compared with the credit terms under the credit granting arrangement.

It is in a company’s best interest not to pay its suppliers sooner than necessary, as this may prove costly in terms of the cost of credit. Likewise, paying suppliers too late, i.e., after the due date may jeopardize the company’s relationship with its suppliers.

Question

Given the following information on companies A and B, what is the number of days of receivable for each company, and which company manages its accounts receivables more effectively?

$$ \begin{array}{c|c|c} {} & \textbf{Company A} & \textbf{Company B} \\ {} & \textbf{(in \$ millions)} & \textbf{(in \$ millions)} \\ \hline \text{Average Accounts receivables} & {2.5} & {3.3} \\ \hline \text{Credit sales} & {7.4} & {9.1} \\ \end{array} $$

A. Company A: 123.31 days; Company B: 132.36 days; Better accounts receivable: A

B. Company A: 123.31 days; Company B: 132.36 days; Better accounts receivable: B

C. Company A: 132.36 days; Company B: 123.31 days; Better accounts receivable: B

Solution

The correct answer is A.

Company A’s No. of days of receivables = (2.5/7.4/365) = 123.31 days

Company B’s No. of days of receivables = (3.3/9.1/365) = 132.36 days

Since 123.31 days < 132.36 days, company A has better accounts receivables management, albeit not by much.

Reading 35 LOS 35f:

Evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies