Thursday, October 14, 2010

Accounting – The Story Behind the Numbers

It seems like the major topic for this week has been related to working capital. In our financial management course, however, there was a great example case where simply knowing the numbers is not enough.

Simplified Case Info (expressed in thousands):

Revenue = 17805
AR = 6000
Average Day’s Receivable in the industry = 59 days


Company’s Average Day’s Receivable = 123 days

Proposed financing solution: Collect on AR to reduce Day’s Receivable to industry average of 59 days.

If Days Receivable = 59 days, implied new AR is 2878. The change in AR would be 6000 – 2878 or 3122.

So looking at this *mathematical* solution, it seems as if the company can get a free 3 million dollars just by tightening its AR, right? Well as it turns out probably not. The reason?

Most companies define default as non-payment of debts of 90 days or more. Previously, we’ve talked about how debts decay in value as they are outstanding for longer and longer (probability of collection and bad debt expense). If you look at this number, essentially what it is saying that the many of your accounts are in default with an average age of 120 days!

Sometimes you can’t just assume you can make operational changes to reflect a reality that you want. The truth of the matter is that those funds are probably lost. The firm probably won’t collect those accounts and will incur a significant bad debt expense.

In reading more of the case, it also mentioned that the company had a “no returns” policy with its distribution channel partners. Looking at this number not only meant that they probably weren’t going to collect, but that their distributors were telling them that they didn’t want to do business with them any more (affecting their potential future revenue growth). Not only will they not be able to pull 3 million dollars out of working capital, there are some critical red flags appearing about their ability to continue as an ongoing concern.

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