Advances received are a fantastic source of financing – interest-free and received prior to the provision of services or delivering products.
Many companies rely on them to finance their operations. This is most common in specialized high-value manufacturing industries, engineering, and construction businesses.
By receiving advance payments, companies are able to finance their working capital on the back of their customers instead of paying interest on bank debt.
How to treat advances in fin. statements analysis?
When companies have large amounts of advances received and/or given, this often blurs the view on actual liquidity.
For example, the normally very useful (Cash + Available credit lines) / short-term debt ratio becomes less valuable because it does not register that the actual cash on balance comes from advances, which, by the way, may have already been spent.
In essence, advances received are a liability, and should be treated as such. If things go wrong, the company may need to return the money received.
It is also important to net advances received with advances given, because many companies channel the part of the advance payments to their subcontractors.
Are all advances received made equal?
No, not all advances are made equal from the cash flow perspective.
Normally, most advances fall into the category of working capital because they are received within the regular course of business to finance operations.
But advances given for Capex should be reported under Capex, and not under the working capital section of the cash flow statement.
Also, in case a company received an advance payment from financing source like an EU fund, it should be treated as a financing cash flow.
So, these things have to be clearly segregated, although they are often summarized under the same line in a balance sheet.
What are the most common practical pitfalls?
The most common practical pitfalls I have seen are the improper allocation to working capital instead of to Capex or financing, and not excluding them from the actual liquidity.
However, the BIGGEST pitfall is a psychological one.
Companies with large advances received tend to ignore the fact that the actual high amount of cash comes from advances, which are liabilities.
And this often gives decision-makers a false sense of sufficient liquidity.
A company with high net advances received is doing fine when sales are growing, but when the trend turns, suddenly there may not be enough cash.
Add a pinch of a high fixed cost base, and things go wrong pretty quickly…
Advances are a great source of financing, but special care needs to be given when this becomes a source your company cannot function without.
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