The term receivables to sales ratio refers to a metric that allows an investor-analyst to understand how accounts receivable moves with sales revenues over time. The metric simply divides accounts receivable by sales revenue; but tracking this metric over time can provide insights into potential misleading sales information.
Receivables to Sales Ratio = Accounts Receivable / Sales Revenues
Liquidity measures allow the investor-analyst to understand the company's long term viability in terms of fiscal health. This is usually assessed by examining balance sheet items such as accounts receivable, use of inventory, accounts payable, and short-term liabilities. One of the ways to understand if a company is providing false information in terms of revenues or profits is by tracking their receivables to sales ratio.
Calculating the receivables to sales ratio allows the investor-analyst to understand if a company might be overstating the level of revenues in a given period. While the level of revenues might fluctuate over time, or demonstrate a seasonal effect, the ratio of accounts receivable to sales revenue typically remains stable from period to period. Since fictitious sales will never result in a cash payment, the only way to hide this practice is by increasing accounts receivable on a dollar-for-dollar basis against the inflated sales value. For this reason, the investor-analyst would compare the receivables to sales ratio over time, looking for an unexpected increase from period to period.
The manager of a large mutual fund has taken an interest in Company ABC's stock. He's also heard whispers that while Company ABC recently lost a large contract with the federal government, their sales revenues has remained unaffected. The manager had his analyst team examine a number of metrics, including Company ABC's accounts receivable to sales revenue ratio over time. Examining the company's recent filings, the analysts produced the table below:
|AR / Sales Ratio||0.35||0.36||0.37||0.44|
The manager's team discovered a spike in the ratio occurring in Q4, which was the same timeframe as the lost federal contract, leading the manager to believe Company ABC may be overstating their sales revenue in Q4.