A company, establishment or society with profits of 500 thousand… yet it owes 3 million! Take, for example, a company, establishment or co-operative society that announces a net profit of KD 500,000. The general assembly applauds. But in the same balance sheet: payables to suppliers of KD 3 million, and receivables (customers and employees) of KD 800,000.
The simple question nobody asks: did the company, establishment or society earn 500 thousand? Or did it live the whole year on its suppliers’ money? If the suppliers asked for their money tomorrow, would you have the cash to pay?
This article uncovers an important side of one of the biggest questions that should be asked when reading a balance sheet: not only how much the entity earned, but who financed its activity, and how much of its profit has actually turned into cash.
The first truth: your supplier may be your biggest financier… without its name ever appearing on the list of loans
In ordinary companies or establishments, when you buy goods for 100 thousand and pay 90 days later, trade credit provides you with short-term financing. And in Kuwaiti societies, payment terms can stretch over long periods, depending on the nature of the activity and the suppliers’ terms.
The key equation:
Average trade financing = annual purchases × average payment period ÷ 360
Example: If your annual purchases are KD 6 million and the average payment period is 120 days: 6,000,000 × 120 ÷ 360 = KD 2,000,000. In other words, your business benefits, on average, from trade financing of close to KD 2 million from suppliers. This amount does not usually appear as a “loan” in the balance sheet; it appears within trade payables. Yet it is an important source of short-term financing.
And this is where the problem begins: if the entity comes to rely heavily on delaying payment, any change in suppliers’ terms can quickly turn into a liquidity crisis. Under IFRS 7, liquidity risk and the management of maturities must be looked at seriously, rather than settling for the payables figure in the balance sheet.
The second truth: receivables… are they money, or profits not yet collected?
The other side is receivables. An entity may sell on credit to employees, customers or other parties, so that receivables running into hundreds of thousands appear in the balance sheet. But the pressing question is not: how much do the receivables amount to? But what matters more: how much of them do we expect actually to collect?
Under IFRS 9, an entity should not wait for a debt to reach the “written-off” stage before it begins to recognise credit risk. The expected credit loss (ECL) model relies on estimating expected losses, drawing on historical experience, current conditions and reasonable and supportable forecasts of the future. For trade receivables to which the requirements of the simplified approach apply, lifetime expected credit losses are recognised.
So receivables of KD 500,000 do not necessarily mean that the economic asset is worth 500 thousand; the collectible amount may be lower once expected credit losses are taken into account.
1. IFRS 18… not for manufacturing profits, but for exposing how they are presented and classified
IFRS 18 will not create new profits, nor will it eliminate existing ones, merely by changing the way they are presented; but it may make the picture of financial performance clearer when income and expenses are classified within the categories the standard sets out. That is why one should be careful not to generalise that every supplier discount or purchase incentive will automatically go to a particular line item. Classification depends on the nature of the transaction, its terms and the relevant circumstances.
The more important message, though, is this:
“IFRS 18 neither makes profits nor erases them; but it may reveal to the user where the profits came from and how they should be presented and classified.”
So if an entity prides itself on a high operating margin, the user of the financial statements is entitled to ask: does this margin come mainly from the core operating activity, or are there other items influencing the picture of performance being presented? This is where the quality of presentation and disclosure becomes an important part of the quality of financial analysis.
Profit that does not turn into cash… is it a comfortable profit?
Management may say: we made a profit of KD 500,000. The question that should follow immediately: How much of this profit has actually reached the bank?
If profits rose by KD 500,000 while receivables rose by 400 thousand and payables rose by 1.5 million, it is not enough to celebrate the profit. We must ask: Has operating performance genuinely improved, or did liquidity improve only temporarily because suppliers financed the business?
This is where the importance of linking the income statement, the balance sheet and the statement of cash flows becomes clear. Profit tells you what has been earned in accounting terms; cash flow tells you what has actually come in and gone out.
The practical solution: 3 reports to ask your accountant for tonight
Report 1: Payables ageing report
A schedule showing: supplier, total balance owed, 0–30 days, 31–60, 61–90, and more than 90 days. Do not look only at total payables; look at their concentration, their ageing and how far they comply with the contractual terms and the suppliers’ credit policy.
Report 2: Receivables ageing report + ECL
The same idea, but with an analysis of collectability and a calculation of expected credit losses under IFRS 9, rather than waiting for the debt to become “written off”.
Report 3: Trade financing indicator
= trade payables ÷ annual purchases × 360
The approximate result gives an indication of the number of days for which suppliers finance part of the operating cycle. But there is no universal rule saying that under 60 days is always good or that over 150 days is always dangerous; the result should be compared with the nature of the business, market conditions, and the entity’s policy and history.
Five questions that reveal the danger zone
If the answer is “yes” to three or more questions, there are indicators that merit investigation and analysis:
- Are payables growing faster than sales?
- Does the average supplier payment period exceed the approved policy or the contractual terms?
- Are receivables growing faster than sales?
- Are profits rising while operating cash flows are falling?
- Does the entity rely heavily on a limited number of suppliers?
These questions do not automatically mean there is a problem, but they help the board of directors, financial management and the auditor to pinpoint the areas that deserve closer examination.
What should management do?
- Set a payment policy that is clear and consistent with cash flows and suppliers’ terms.
- Negotiate early-payment discounts when the economic return on the discount is better than the cost of holding cash.
- Monitor receivables regularly, and do not wait until overdue debts pile up.
- Link the sales, collections, purchases and payments reports to cash flows.
- Review supplier and customer concentration, because excessive reliance on a single party can turn into an operating and financing risk.
- Base credit decisions and allowances on data and analysis, not on impressions alone.
Conclusion: who financed the profit? And how much of it turned into cash?
A balance sheet showing large payables is not necessarily strong; it may belong to an entity financed by its suppliers. And a balance sheet showing large receivables is not necessarily rich; it may belong to an entity that sold a great deal and did not collect. Profits alone are not enough to judge an entity’s strength.
The real question is not: how much did you earn? But rather: who financed this profit? And how much of it turned into cash?
Profit is a figure in the income statement… liquidity, however, is the test of the ability to carry on. In the end, the balance sheet doesn’t lie… but it tells the whole truth only to those who know how to read between its figures.
