How Increasing Trade Receivables Days Is an [Potential] Early Warning Sign

What are trade receivables and trade receivable days?

Trade receivables is nothing more than sales that were done in credit. Depending on industries, trade receivable credit terms could be 30 days to 90 days. As a business, you would like to have very low trade receivables or none.

Trade Receivable Days is simply nothing more than trade receivables multiply by 365, then divided by the revenue (sales). It measures the efficiency of a company to collect its credit sales into cash.

Again, we should always compare similar businesses together. For example, Foxconn Technology (2354) takes roughly 50 – 60 days to collect their receivables. Looking at Walmart, it takes just 3 – 4 days to collect their receivables. Most customers pay in cash except certain corporate customers.

As usual, I was performing my analysis on a company. Everything looks good except I dug further into the footnotes and noticed a serious issue regarding its trade receivables days. It is increasing.

It jumped from 58.54 days to 78.08 days, which is a bit troubling for me. This clearly shows that the quality of the customers had deteriorated, or the company relaxed its credit policies by allowing customers to take a longer time to pay.

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In other instances, there were companies who wanted to grow sales so badly, the salesperson was encouraged to sell products/services to customers who do not have the ability to pay up. The subprime mortgage crisis was partially caused by lenders providing credit to borrowers with poor credit scores. The respective bank salesperson was highly incentivised to do it for their bonuses. Likewise, for companies, they might do so to grow their sales and profits. Never mind about what happens when the customers cannot pay up for the products/services.

Alright, let’s get back the company that I was talking earlier. An investor ought to dig deeper into the quality of trade receivables when the receivable days increase dramatically.

Firstly, the company suffered an impairment of trade receivables and thus affecting the computation of trade receivable days. It jumped from RMB $13.4m to RMB $22.4m – a jump of 67%. Naturally, a healthy growing company with solid credit policies should not suffer any impairments at all. It is practically meaningless to show profits on your income statement when you cannot collect it as cash. Remember, cash flow is the ultimate factor for valuations.

Secondly, the company suffered amortisation of intangible assets of RMB $16.3m. It was huge however I have yet to find out the reason for it.

This prompted me to search for its ageing trade receivable analysis.

It is seen that RMB $179.4m of trade receivables are past due BUT not considered to be impaired. What are the chances of fees collection? If it is low, this amount should be impaired away. To put things in perspective, the company’s total trade and bills receivables is RMB $258.9m as of latest 31 Dec 2017. Taking RMB $179.4m divided by RMB $258.9m, it is an alarming 69%.

After looking at its industry peers and checking with the management, I’ve determined that the delayed trade receivables amount is not an issue.

Given such high risk, despite solid fundamentals or valuations, you may have to dig deeper. It may not be a direct rejection. 

Looking at another company… Swiber Holdings is a leading global company in the offshore industry, providing a wide range of Engineering, Procurement, Installation and Construction (“EPIC”) services.

(view financials at Morningstar)

You can see that its trade receivables day was 156.5 days in 2007 where there was a financial crisis. Subsequently, the trade receivable days shot up from 98.38 days to 144.96 days (2010 to 2015). This signified a significant deterioration in customer quality.

(page 57 of Swiber’s Annual Report FY2015)

As of 2015, it had US$ 442.215m of trade receivables. The figure was US$454.342m in 2014.

(page 116 of Swiber’s Annual Report FY2015)

For FY2014, the amount of trade receivable past due but not impaired was 24.3% (110387/454342) of total trade receivables. The situation got worse.

For FY2015, the amount of trade receivable past due but not impaired was 49.5% (219265/442215) of total trade receivables. Since it is operating in a cyclical industry, we should not be overly optimistic that Swiber is able to turn these receivables into cash. To understand the impact further, for FY2015, Swiber’s equity was US$485.381m. An entire cleaning of past due trade receivables, it would reduce its Swiber by US$219.265m, the worst-case scenario would be a resulting equity of US$266.116m. A drastic drop of 45%.

Due to lack of cash flow to address debt issues, Swiber was placed under judicial management and it defaulted on its bond coupon payment. Many shareholders and bond holders got burnt during the process.

Hope you find this simple observation of trade receivable days useful to prevent you from serious losses from investing in not-so-good businesses.

Hope you enjoy this short  but interesting article!

Summary 

• Watch out for companies with rising trade receivable days. The credit quality of customers may be deteriorating.
• Check for the ageing trade receivable analysis.
• Earnings are nothing, cash flow is everything.
• The ability to collect trade receivables depends on the constant monitoring and the industry where it operates as well.
• Contact the management or look at similar industry peers to understand whether this is an industry-specific or company-specific issue.

PS: Wishing my Muslim readers… Selamat Hari Raya Aidlifitri!