Sunday, April 8, 2012

Energy Sector: Integrated Oil & Gas - Quality of Earnings, Accounts Receivable

For the next quality of earnings indicator in our investment analysis, we're going to look at is Accounts Receivable. 

The calculations for Accounts Receivable are identical to Inventory.  To begin, we collect the three most recent years of revenue and the three most recent years of accounts receivable.

I should probably discuss where each of the line items I use is found.  Accounts receivables and inventory are balance sheet figures, found near the top under current assets.  Revenue or sales is the top line on the income statement.

We need to pull:
  • Total revenue, Y, Y-1, and Y-2
  • Accounts Receivable - Trade, Net, Y, Y-1, Y-2.
And from this information we need to make five calculations:
  • Expected Sales,
  • Expected A/R,
  • % change in Sales,
  • % change in A/R,
  • % change in Sales - % change in A/R.
We proxy expected sales and expected A/R with an average of Y-1 and Y-2.  % change in sales and A/R is:
(Sales Y - Expected Sales)/Expected Sales.

If the percentage change in sales minus the percentage change in a/r is negative, that is an unfavorable signal.

Let's understand the logic.

If our actual sales is greater than our expected sales, we have a positive number.  The same reasoning applies to a/r.  When we take the difference between the % change in Sales and the % change in A/R, if accounts receivable has grown more than sales we get a negative number and a negative signal.

Lev & Thiagarajan discuss how disproportionate a/r increase can indicate sales difficulties (triggering credit extensions) as well as future bad debt write-offs.

I think of it like this - accounts receivable is a component of sales, but they're only on paper.  A sale on paper is not as good as a sale realized in cash.  The reasons are noted above and it's also because it can be indicative of aggressive policies that make the likelihood of actually collecting even more remote (cash is always king). So when I see the less desirable accounts receivable component growing as a percentage of all sales, it's a red flag.

I use the same rating system: 1 is a positive outcome, -1 is negative and 0 is a null or neutral result.  I use an "if, then" formula, rather than plugging the numbers in for each stock.  Verdasis was designed with normalized data - meaning that when it pulls new financial statement information, each Y, Y-1, Y-2 etc is automatically updated - this means that your data doesn't go stale and your ratings can change.

You can see the spreadsheet here:

The next factor we're going to look at is research and development.  These calculations are different from the inventory and accounts receivable ones.

Thank you for reading and I'll be back to you by the end of the week.

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