Accounts receivable is often the largest working capital liability a buyer inherits in a small acquisition—and it’s where the most sophisticated sellers hide problems. You close the deal believing the balance sheet shows $500K in AR, only to discover three months later that 15% of those invoices will never be collected. By then, you’ve already paid for that receivable and written the check to the seller. This section of financial due diligence is not optional; it’s the difference between buying a predictable cash-conversion business and inheriting a collection nightmare dressed up as revenue.
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Why AR Quality Matters in Deal Economics
In an SDE or EBITDA calculation for a small business, accounts receivable typically shows up two places: (1) as a balance sheet line item that affects working capital peg, and (2) implicitly in normalized revenue, which assumes that sales were actually collected or are collectible. A working capital peg—usually set at a percentage of trailing revenue or trailing SDE—locks in the buyer’s expectation of how much cash tied up in AR is “normal” for this business. If the business actually has 60 days of sales sitting in uncollected AR because collection practices are weak, that’s one problem. If 20% of the AR balance is uncollectible but was booked as revenue, you’ve overpaid by the full amount of that reserve.
The seller’s incentive is transparent: AR balance on the closing date becomes part of the working capital adjustment that reduces what they receive. A seller with weak collections motivation will minimize reserves and maximize the AR figure, knowing they won’t manage those receivables post-close. The buyer, by contrast, faces the cash drag immediately.
The AR Audit Checklist: What to Review
Before closing, obtain and analyze these documents from the seller:
- Aged AR schedule—The complete accounts receivable aging by invoice date, typically buckets: current (0–30 days), 31–60, 61–90, 90+. Request this in both list and summary format. Any invoice over 90 days is a red flag regardless of customer creditworthiness.
- Customer concentration report—The top 10–20 customers by AR balance. A business where one customer represents 40% of AR is higher risk than one with diversified collections.
- Bad debt reserve detail—How much has the seller reserved? For how many customers? What’s the historical write-off rate? If reserves are zero or artificially low, ask why.
- Collections history—Remittance patterns for the past 12 months. Do certain customer segments always pay late? Is there a seasonal pattern?
- Credit memos and disputes log—Revenue reversals, warranty claims, or disputed invoices. A spike in these indicates either quality issues or weak customer relationships.
The Calculation: Establishing a Defensible Reserve
Here’s a concrete method used by experienced buyers and their advisors. Start with the aged AR schedule and segment by customer risk profile.
Step 1: Categorize customers by credit risk. Your due diligence should include a credit check on the top 5–10 customers. Are they established, creditworthy entities or small operations with no public credit history? A $2M contract manufacturer selling to Fortune 500 customers has vastly different collection risk than a staffing company with dozens of small contractors.
Step 2: Apply a historical loss rate to each cohort. If the seller has 12 months of write-off data, calculate the actual bad debt loss as a percentage of beginning AR for each aging bucket. Don’t accept the seller’s stated reserve; derive your own. Example:
- Current AR (0–30 days): 2% historical loss rate
- 31–60 days: 5% historical loss rate
- 61–90 days: 15% historical loss rate
- 90+ days: 40% historical loss rate
If the seller has no written loss history, use industry benchmarks—trade credit groups and credit bureaus publish sectoral averages—and apply a conservatism adjustment upward.
Step 3: Segment by customer concentration. A $100K invoice from a customer who represents 30% of revenue is riskier than a $100K invoice from a diversified customer. Reserve more aggressively for concentrated balances, especially if the relationship is new or based on a single order.
Step 4: Run the math. Imagine the seller’s aged AR schedule shows:
- Current: $400K × 2% = $8K reserve
- 31–60 days: $150K × 5% = $7.5K reserve
- 61–90 days: $75K × 15% = $11.25K reserve
- 90+ days: $25K × 40% = $10K reserve
- Concentration adjustment (top 3 customers at 55% of balance): additional $6K reserve
Your calculated reserve is ~$43K against a $650K AR balance. If the seller’s reserve is $5K, you’ve identified a $38K gap. That gap is working capital that the buyer must fund but the seller did not account for.
Digging into Structural Red Flags
Beyond the numbers, certain patterns suggest AR quality problems that a simple aging schedule won’t surface.
Consecutive invoices to the same customer, never paid. If a customer has three invoices over 90 days unpaid and the seller is still shipping to them, collection efforts are weak or the relationship is broken. This is not a “normal” receivable; it’s a delinquency masquerading as revenue.
Large AR swings month to month without corresponding revenue swings. A business that reported $200K revenue in October but AR increased by $300K, then reported $150K in November and AR stayed flat, suggests either invoice timing games or a single large customer delaying payment. Reconcile this to the customer ledger.
AR aging that doesn’t reconcile to trial balance. Request the aged AR schedule and tie every line to the general ledger AR control account. If they don’t reconcile, stop. This is an immediate red flag that accounting records are unreliable.
Frequent invoice rebates, returns, or credits issued after shipping. A business that regularly issues $50K in credits post-invoicing is either (a) delivering poor quality, (b) accepting weak customer terms, or (c) both. This erodes the true quality of revenue.
The Role of AR in Working Capital Peg Disputes
Many LOI terms specify that working capital will be true-up after closing, usually using a working capital peg (e.g., “AR equal to 40 days of trailing revenue”). If the buyer discovers post-close that actual AR is 55 days of sales, the peg shortfall comes from the seller’s proceeds. Conversely, if AR is only 30 days, the buyer overfunded working capital and receives a credit.
This mechanism only works if the initial AR balance is credible. If 15% of the opening AR is ultimately uncollectible, you’ve paid working capital for cash that never materialized. The post-close adjustment won’t fix this; it adjusts based on the peg formula, not on actual collectibility.
Raise this issue pre-close: propose a mutually agreed reserve for specific high-risk invoices, and adjust the closing AR balance downward by that amount. This avoids disputes and protects both parties’ interests.
Integration with Normalized Earnings
AR quality feeds directly into how you normalize EBITDA or SDE. If the seller claimed $2M in revenue but 10% of the corresponding AR will never be collected, that’s $200K in non-recurring loss. Do you adjust revenue downward, or assume the loss will manifest as a post-close bad debt write-off? Most buyers record it as a one-time adjustment to normalize earnings, demonstrating that historic revenue was overstated and EBITDA or SDE was artificially inflated.
Similarly, if the seller has been under-reserving for years, you may normalize by adjusting for a more conservative reserve level. This doesn’t change the AR balance but clarifies what normalized earnings actually look like once you apply industry-standard collection practices.
Post-Close Verification
On or just before closing, take an updated aged AR schedule dated at the close of business on the closing date. Compare it to the pre-close schedule the seller provided. Watch for:
- Sudden large payments received days before close (a seller collecting hard to artificially improve the AR quality for measurement purposes).
- New delinquencies that appeared between pre-close data and closing date.
- Invoices issued immediately before close but dated before close (a timing game to inflate revenue in the last reporting period).
Your data room should include the signed closing statement reflecting the agreed-upon opening AR balance and any working capital peg adjustment. If the verified AR differs from that amount, document it; this becomes the basis for any working capital dispute resolution under the purchase agreement.
Frequently Asked Questions
What’s a reasonable bad debt reserve for a small acquisition?
It depends entirely on the business model and customer base. A B2B staffing company with small, high-turnover customer lists might reserve 5–8% of AR. A professional services firm with large corporate clients might reserve 1–2%. The key is to derive the reserve from the seller’s actual historical loss data, not a generic rule. If loss history is absent or unreliable, add a conservatism buffer—typically 2–3% above calculated rates—to account for unknown risks.
Should I ask the seller to carry an AR reserve post-close as a seller note or holdback?
Not as a substitute for pre-close verification. If your analysis shows that specific invoices are genuinely collectible but carry collection risk (e.g., a creditworthy customer with a 75-day payment history), you might negotiate a brief holdback tied to collection within 90 days post-close. But this is rare in small deals under $10M and usually adds complexity. Instead, agree on a downward adjustment to the AR balance at close for any invoices either party agrees are uncollectible, and proceed from a cleaner baseline.
How do I reconcile the aged AR to the general ledger?
Obtain the AR control account balance as of the close date from the trial balance or balance sheet. Sum all lines on the aged AR schedule by customer; the total should equal the control account. If it doesn’t, ask the seller to explain the difference—common culprits are unapplied cash, credit memos not yet posted, or duplicate invoices. Until this reconciliation is clean, you don’t have reliable data for reserve calculations.
What if a customer disputes an invoice after I close?
Disputes discovered post-close are the buyer’s responsibility unless the purchase agreement has specific carve-outs for pre-close disputes. This is why pre-close verification of disputes and credits is critical. Request a disputes log from the last 12 months and reconcile it to your opening AR schedule. Any unresolved disputes should reduce opening AR or increase reserves accordingly.
Can I use Outsourcing Processing to organize and verify my AR calculations?
The platform can help you organize and calculate normalized EBITDA and SDE, factoring in adjustments for AR quality issues you’ve identified during due diligence. For example, if your analysis shows a need for a $30K AR reserve uplift, you’d input that as a one-time adjustment to normalize earnings. The platform organizes the data and calculations in a structured format—human-reviewed, never auto-applied—making it clearer for your advisor or attorney to review before close. This is a faster first pass than a full traditional Quality of Earnings engagement and works well for smaller acquisitions where your diligence team is managing the analysis in-house.
This article is educational and does not constitute M&A, investment, or accounting advice — confirm findings with a licensed CPA or M&A advisor before making an offer.
This article is educational and does not constitute M&A, investment, or accounting advice — confirm findings with a licensed CPA or M&A advisor before making an offer.
This is exactly the kind of adjustment IncomeReady keeps organized and ready for your review.