How do I analyze accounts receivable using aging schedules, allowance methods, and DSO?

Accounts receivable analysis is critical for assessing a company's credit policies, collection efficiency, and potential earnings manipulation.

Allowance for Doubtful Accounts

Companies rarely collect 100% of their receivables. They estimate uncollectible amounts using two approaches:

1. Percentage of Sales Method: Applies a fixed percentage to credit sales. Simple but ignores the existing allowance balance.
2. Aging Method: Categorizes receivables by how long they've been outstanding and applies progressively higher loss rates.

Example -- Meridian Distribution Co.:

The required allowance is $43,000. If the current allowance balance is $30,000, the company records $13,000 in bad debt expense.

Net Receivables = Gross Receivables - Allowance = $820,000 - $43,000 = $777,000

Days Sales Outstanding (DSO)

DSO = (Average Accounts Receivable / Revenue) x 365

If Meridian has average receivables of $780,000 and revenue of $4,500,000:

DSO = ($780,000 / $4,500,000) x 365 = 63.3 days

Red Flags to Watch:

• Rising DSO over time suggests slower collections or loosened credit terms
• Allowance ratio declining while receivables grow may signal management understating bad debts to inflate earnings
• Large write-offs after years of low provisions indicate prior earnings were overstated

Receivables Turnover = Revenue / Average Receivables = $4,500,000 / $780,000 = 5.77x

Exam Tip: Always check if receivables are growing faster than revenue -- this divergence is a classic red flag for aggressive revenue recognition.

Practice receivables analysis in our CFA Level I question bank.