Accounts payable

Accounts payable, or simply payables, are the trade credit that is extended to a company by its suppliers.  Payables are liabilities, things the company owes to others.  In almost all instances payables are current liabilities, and, as such, part of working capital.  There are rare instances, however, where they are long-term liabilities.  I gave an example of oilfield service company behavior after the mid-Eighties collapse in energy prices in my post on receivables.  The corresponding item to the long-term receivables on the oilfield service balance sheet would be the long-term payables on its customers’.

Two ratios

There are two payables ratios of primary interest to a securities analyst:  payables/sales and payables/receivables.  Both are calculated using the payables and receivables figures taken from the balance sheet of a certain date.  The sales figure used is for the twelve months ending on the balance sheet date.

The ratios are compared, first and foremost, with a company’s own history.  But since a supplier normally provides customers with more or less standard raw materials on more or less standard payment terms, it is also reasonable to compare the payables to sales ratios among different firms in a given industry.  The results will give a first approximation for the relative market strength and relative bargaining power of industry participants.

1.  receivables/payables. Receivables/payables is a way of quantifying the relative strength of a company vs. suppliers and customers in the universe it operates in. In a CEO’s ideal world, customers would be so eager for the company’s products that they would pay in cash–or even in advance (therefore, no receivables)–and suppliers vying for the privilege of supplying the company would provide unusually long payment terms (big payables).  In CEO hell, on the other hand, suppliers would be so worried about the financial viability of the company that they would demand payment up front (therefore, no payables) and customers would take the finished product only if they could obtain (a la Chrysler) unusually generous financing (big receivables).

As a general rule, the bigger the number, the weaker the position of the company in question.  It’s also important to examine the historical record.  Is this ratio constant over time, or has it recently begun to signal strength or weakness?

Look at the raw numbers, too

In addition to looking at the ratio, you should look at the raw numbers as well–and in two ways.  First, consider how much of the overall credit extended to customers by a company is in effect being financed by credit it is receiving from suppliers.  Then look at the increase in receivables over the previous, say, three years and compare that with the increase in payables.  Do the competitive dynamics of the company’s industry allow the company to keep any of the benefit of increased credit from suppliers?  or has the company been forced to simply pass this financing benefit on to customers?

2.  payables/sales Decline in this ratio can be a very important early warning sign of impending trouble for a company.  Suppliers are constantly analyzing the prospects of all their customers.  Because they deal with a wide variety of firms in their targeted industries, and because they see the pattern of their customers’ payments for supplies, they possess a very sophisticated picture of the industry and each company’s place in it.

Trade creditors are also at the bottom of the pile when it comes to recovery during liquidation.  So they have a lot to lose if they continue to send materials to a failing customer.  As a result, shrinkage in payables is a very reliable indicator of potential trouble.

What receivables are

When a company performs a service or ships a product to a customer, it also submits a bill or invoice.  The amount of time the customer has before payment of the invoice is due varies from industry to industry.  Payment terms can also change, based on negotiation between the parties involved.  Terms can also include a discount for early payment or penalties for late payment.

The total of all of a company’s not-yet-paid invoices is listed on the asset side of the balance sheet as Accounts Receivable. Except under the most unusual circumstances (see below), receivables are listed as Current Assets.  They are a key component of working capital.

How analysts look at receivables:  receivables/sales

A securities analyst most often begins to look at receivables by calculating a receivables/sales ratio for different time periods:

–that is, the ratio of outstanding receivables at a specific balance sheet date to total sales for the twelve months ending with the balance sheet date.

The analyst then looks for any pattern or trend that may appear in the ratio over the past few years.  For an industry with distinct seasonal variation in sales and receivables (think:  toys or jewelry), the best comparison to consider when inspecting for trends is year over year.  For those without seasonality, quarter on quarter comparison may be equally good.

(An aside:  Some people prefer to look at receivables/cost of goods.  I’ve never quite gotten why, and in my experience you don’t get materially different results, but I suppose it shifts emphasis to seeing how long it takes a firm to recover its cash outlays rather than making a profit.)

Note, too, that receivables are customarily listed net of (i.e., after deduction of) an allowance for doubtful accounts. That’s a provision, based on the company’s historical experience, for receivables that will probably never be paid.  Apple, for example, lists $3,361 million in receivables on its 9/26/09 balance sheet.  That’s after a $52 million doubtful accounts allowance.  I suppose you could analyze the doubtful accounts provision for patterns. I’ve never done it, so I don’t know what you’d find.  But since the allowance gradually adjusts, based on recent deviations from past experience, my guess is that this would be a lagging indicator.

The ratio’s significance

Why is the receivables/sales ratio important?  Assuming no changes in the company’s business lines, receivables/sales should be relatively stable.  If the ratio begins to deteriorate–that is, if the number gets bigger–it can be one of the earliest signs of weakening in a company’s business.  Of course, it’s not the only sign.  If the company is having trouble, there will likely also be indications in the behavior of inventories (they get bigger) and payables (they get smaller).  But receivables/sales is very reliable.

The general idea is that the credit terms offered to customers are one of a collection of factors that influence a customer to choose one company’s products over another’s.  It’s one of the easiest factors to alter for a firm chasing a reluctant buyer.  A rising receivables/sales ratio is balance sheet evidence that the company is either offering extended payment terms to current credit customers or offering credit to customers who previously were asked to pay cash.  It is presumably doing this to win sales it would not get otherwise.  In other words, demand for its products is less than it has previously been.

One may also try to compare receivables/sales across different companies in the same industry.  In theory, the ratio should be the lowest in the strongest companies and highest in the weakest.  The practical difficulty is in finding companies with similar enough business mixes for the comparison to be valid.  For instance, even a relatively simple business that sells mostly at wholesale would have a different receivables pattern than one in the same industry that sells mostly at retail.

Examples

You may remember that Mitsubishi Motors had a sales campaign several years ago that offered liberal financing, featuring:

–zero down payment

–zero interest rate, and

–zero payments for one year.

It did a ton of financing and sold a ton of cars.  But it found out, starting about a year later, that almost zero people intended to make any payments on these loans.  (Yes, I’m sure this financing was done off-balance sheet.  My point is that having to offer sweetened financing terms is virtually always a sign of trouble.)

Similarly, as I’ve mentioned in another post, when Chrysler was going through bankruptcy, it came to light that a third of its customers were sub-prime credits who were buying Chryslers because no one else would lend them money to buy their cars.

Quirks to be aware of

1.  Companies sometimes factor receivables, i.e. sell them to third parties, to get them off the balance sheet.  If so, this fact will be disclosed in the Notes to Consolidated Financial Statements, either in the Accounts Receivable footnote or in the first footnote–Summary of significant accounting principles. Factoring receivables, even if it’s done to make the balance sheet look better than it would otherwise, may be a relatively benign thing.  If a company is really having difficulties, counterparties will quickly work this out and decline to purchase further receivables.

2.  The customary format for the physical layout of the balance sheet is to have current items listed at the top, with long-term items below them.  Occasionally, you will see some receivables listed as long-term items–indicating payment is not due for at least a year.  Sometimes, these can be innocuous entries that mirror the terms of a multi-year contract.

In other cases, however, this can be an attempt by a troubled company to divert attention from its financial/operating difficulties.  In the early Eighties, during the oilfield slump following the second “oil shock” of the Seventies, I was an oil analyst.  I saw oilfield service companies that had bloated inventories of the steel pipe (used to line the sides of oil/gas wells) that were starting to rust in their distribution yards.  Some told their customers, in effect–please take as much pipe as you can and pay us when you’re able.  To the extent that customers did, that shifted the (worthless) inventory out of current assets and into (worthless) long-term receivables.

This was, of course, only a cosmetic alteration.  But it may have made the company managements feel better.  And it may have fooled some careless investors.