Where receivables are defined as accounts and notes receivable. We penalise companies with a high and/or rising level of receivable days relative to industry peers. There are a number of reasons to be concerned about receivables:
- Poor competitive advantage or hidden bad debts: Persistently large receivables relative to peers might suggest that the company is giving more advantageous credit terms to customers. This is clearly not a very compelling competitive advantage. Alternatively, it might suggest that the company has long overdue outstanding receivables that it cannot collect upon. As such, investors should check the receivable ageing schedule within notes to the financial statements. If this is the case, it is possible that the company has been over-stating profits and a future impairment is a possibility.
- Deteriorating terms of trade or increasingly aggressive income recognition: We would regard deteriorating receivables as being potentially far more problematic than a large receivable. Either terms of trade are worsening or the company is being more aggressive in sales recognition to boost profit. Neither is a good outcome. If the receivable deterioration is significant enough, it will be mirrored by a dip in operating cash flow relative to profit, all other things being equal. However, companies often mask this operating cash shortfall by passing the burden onto their suppliers in the form of extended payables. In some extreme cases, we have had suspicions that payables are simply a form of debt disguised as working capital. For example, when Kaisa (1638 HK) defaulted in 2015 it was subsequently disclosed that the company had failed to disclose to auditors that certain short term liabilities were interest bearing, and should thus be re-classified as debt. As such, investors should carefully monitor how a company generates its operating cash flow.
In general, industries with compelling business models (i.e. strong barriers to entry and multiple customers with low bargaining power) often have relatively low receivables (i.e. they get paid quickly) compared to those which are commoditised (i.e. low barriers to entry and fewer customers with stronger bargaining power). For example, machinery and electrical equipment industries (which is a commoditized business) typically record average receivables at 20-30% of sales (80-90 days), compared to retailers at 1-5% (less than 20 days), as shown in Figure 5.
Changes in receivables are equally insightful. A lengthening of receivables can indicate that a company’s terms of trade are deteriorating, or that it has become increasingly aggressive in sales recognition (presumably, in order to meet profit forecasts). Certain industries are more prone to more volatile receivables than others. For example, the energy equipment and construction industries see receivables fluctuate by 3-4% of sales (11-16 days) in any given year, while it is unusual for retailers to record any material change at all, as shown in Figure 6.
Our accounting screen is set to trigger a red flag when receivables/sales exceed the 80th percentile (i.e. it is very high) relative to GICS industry peers, and/or when there is an abnormally large deterioration relative to the normal rate of change amongst industry peers over one and three years. This latter red flag is triggered when the deterioration in receivables exceeds the 80th percentile relative to the change experienced by industry peers between 2010 and 2015. For further reading on receivables please refer to GETTING PAID? Receivables in Asia (3 Dec 2014) and HIDDEN DEBT: And Manufactured Cash Flow (25 May 2016).