598 CHAPTER 16 Working Capital Management
financed in some manner, but (3) that the entire amount of receivables does not have
to be financed because the profit portion ($200 of each $1,000 of sales) does not rep-
resent a cash outflow. In our example, we assumed bank financing, but, as we discuss
later in this chapter, there are many alternative ways to finance current assets.
Monitoring the Receivables Position
Investors — both stockholders and bank loan officers — should pay close attention to
accounts receivable management, for, as we shall see, one can be misled by reported fi-
nancial statements and later suffer serious losses on an investment.
When a credit sale is made, the following events occur: (1) Inventories are re-
duced by the cost of goods sold, (2) accounts receivable are increased by the sales
price, and (3) the difference is profit, which is added to retained earnings. If the sale
is for cash, then the cash from the sale has actually been received by the firm, but if
the sale is on credit, the firm will not receive the cash from the sale unless and until
the account is collected. Firms have been known to encourage “sales” to very weak
customers in order to report high profits. This could boost the firm’s stock price,
at least until credit losses begin to lower earnings, at which time the stock price
will fall. Analyses along the lines suggested in the following sections will detect any
such questionable practice, as well as any unconscious deterioration in the quality of
accounts receivable. Such early detection could help both investors and bankers
avoid losses.^9
Days Sales Outstanding (DSO) Suppose Super Sets Inc., a television manufac-
turer, sells 200,000 television sets a year at a price of $198 each. Further, assume that
all sales are on credit with the following terms: if payment is made within 10 days,
customers will receive a 2 percent discount; otherwise the full amount is due within
30 days. Finally, assume that 70 percent of the customers take discounts and pay on
Day 10, while the other 30 percent pay on Day 30.
Super Sets’s days sales outstanding (DSO),sometimes called the average collection
period (ACP), is 16 days:
DSO ACP 0.7(10 days) 0.3(30 days) 16 days.
Super Sets’s average daily sales (ADS)is $108,493:
(16-6)
Super Sets’s accounts receivable, assuming a constant, uniform rate of sales through-
out the year, will at any point in time be $1,735,888:
Receivables (ADS)(DSO) (16-7)
($108,493)(16) $1,735,888.
200,000($198)
365
$39,600,000
365
$108,493.
ADS
Annual sales
365
(Units sold)(Sales price)
365
(^9) Accountants are increasingly interested in these matters. Investors have sued several of the major ac-
counting firms for substantial damages when (1) profits were overstated and (2) it could be shown that the
auditors should have conducted an analysis along the lines described here and then reported the results to
stockholders in their audit opinion.