Many companies offer to sell products to their customers on credit. When a company sells products on credit it records the full value of the sale as revenues immediately. In addition, it may earn future interest income as the loan is paid off. Although the practice is common and legitimate, it also can frequently be a source of trouble for the lending company. Analysts and investors should always be on the alert for potential problems when considering a company that offers financing to its customers.
The first potential issue is that the customer is unable to repay and the company does not actually receive the cash it has already booked as revenue. To guard against this risk, companies do not book all of the revenue up front, but rather reserve some of it as an allowance for potential bad debts. We have discussed in the past these issues, particularly as they relate to Xerox. To spot potential trouble investors can look for changes in the allowance for doubtful account relative to the level of financial receivables and sales.
The second issue is that companies (or their commissioned salespeople) may have an incentive to make sales to customers with questionable credit quality. During the telecom boom in the late 1990’s, Lucent and Nortel sold an enormous amount of equipment to startup companies that ended up going bankrupt. Although the equipment makers were able to take back the equipment, there were no other buyers for it. Investors should look out for this when financial receivables are growing at a faster rate than overall sales, as it may be a sign that the company has targeted lower credit quality customers.
Similarly, companies may temporarily offer enticing financing arrangements in order to boost sales levels in a given quarter to meet earnings or sales targets. Management bonuses may be significantly impacted by such short-term factors. This is harder for investors to spot. Some management compensation disclosures, found in proxy statements or 8k reports, may be useful for determining target sales levels. This is also an area where Peter Lynch’s “invest in what you know” philosophy can pay off. Industry insiders are more likely to know when their own company or a competitor is issuing short-term incentives to boost sales.Like this article? Why not try out: