If you want to evaluate the health of a company, backtest the accounts receivable and accounts payable of that company. AR (accounts receivable) and AP (accounts payable) are just one way to look at a company’s performance in the stock market.
What does accounts payable and accounts receivable mean?
Accounts receivable means the amount of money that a company is owed by its customers and will be paid. Here is an example; if you want to purchase a brand new smartphone, but maybe you don’t have all the cash up front, the phone is sold on credit and you make monthly payments. This would be an account receivable to that company.
Accounts payable means the amount of money a company owes other companies and will pay in the future. Let’s use an example off a small clothing boutique that purchased inventory from a particular brand. The boutique would owe that brand/supplier money, and the money would be the accounts payable the boutique is obligated to fulfill in the future.
If a company manages these accounts appropriately, it will add to its long-term profit, financial health, low investment risk, working capital, profitability, and cash conversion rate. What if you look at a company’s AR and AP, and it doesn’t look good? (You will be grateful to us for showing you how to spot a non-organic lemon concentrate, aka red flags!)
The Accounts Receivable/Payable of a Lemonade Stand
Maybe you’re still wondering what AR and AP mean in simpler terms. Well, the growing success of the lemonade stand owned by Rebecca now has to keep track of the monthly AR and AP.
Rebecca has established her business in a familiar community. She knows her customers well and will sell them lemonade on credit. On average, Rebecca sells 30 cups of lemonade monthly on credit, equivalent to $90 in revenue. When customers purchase a cup of lemonade on credit, they have a month to pay it back. The $90 amount owed to Rebecca is the accounts receivable for the lemonade stand.
Rebecca purchases her lemons monthly from one local supplier for $100 to make the best lemonade. The supplier provides an invoice with the requirement of paying the money back within 30 days. Rebecca is now liable to pay the supplier within the specified 30-day period. The $100 owed to the supplier is the accounts payable for the lemonade stand.
AR = $90
AP = $100
As Rebecca’s lemonade stand expands, she will purchase more materials from suppliers and have more customers using credit. Rebecca needs to record and understand the incoming money from AR and her obligations in the future for the AP to manage the financial aspects of her business correctly.
Accounts Receivable/Payable Out in the Wild
If you are understanding the concept but want to see it in play on a larger scale, keep reading. Let’s consider a real company, Starbucks. Starbucks is iconic for being one of the world’s largest coffee chains and getting people hooked on caffeine across the globe. They are one of the first coffee stores to transform their transactions digitally.
A customer walks into Starbucks and gets 1 drink for $5 using the mobile app, but the customer decides to pay later using a stored value in his/her account on the app. Starbucks records a $5 AR for that client because they owe Starbucks for the coffee until the payment on the app is made. If that exact transaction occurs 20,000 times a week, Starbucks would have $100,000 in AR. Then with 4 weeks in a month, Starbucks would have $400,000 in AR per month.
Starbucks serves quite a few people, so the company must have quite a few suppliers. If just one agreement to purchase coffee beans from a supplier is $100,000 a month, and they have 3 coffee bean suppliers just in Guatemala (you gotta try some of that coffee), then by the end of the month, Starbucks has $300,000 in AP.
The previous numbers are all hypothetical, but these aren’t. Starbucks buys roughly 3% of the world’s coffee spanning 30 countries, 400,000 farmers, all equivalent to 800 million pounds of coffee a year. If those are the numbers, imagine the AR and AP of the global coffee chain.
Why Equities Lab
Here at Equities Lab we strive to educate and demonstrate why concepts such as accounts receivable and accounts payable should impact how you evaluate the stock market. Using the software at Equities Lab, you can easily compare accounts receivable from 1 quarter ago to the accounts receivable from 2 quarters ago, and the same with accounts payable. there is more to learn about how you can evaluate a company’s performance and what the outliers of AR and AP mean. If a company can wisely handle its accounts and demonstrate growth, that’s good news! But the moment there are mishandlings with AR and AP, you’ll be educated enough to spot it. With that information and a variety of formulas, you’ll be ready to find growing companies (and maybe a few that you want to avoid). Keep up with our content to see examples of how Equities Lab evaluates AR and AP.