Debt is the obvious warning sign investors look for. But before a company takes on more debt, something else may already be happening on its balance sheet: trade receivables are growing faster than sales.

A rise in receivables is not necessarily a problem. A growing company will naturally have more money due from customers. The warning sign is when receivables consistently grow much faster than sales, suggesting that an increasing share of the company’s reported growth is yet to turn into cash.

The question is not simply how fast a company is growing, but how much of that growth it has to finance itself. A company that continually provides more credit to customers is, in effect, financing part of its customers’ businesses. Shareholders should ask whether the returns from the additional sales justify the cash being tied up.

Financing Growth
Consider a company whose sales rise 40%, but whose trade receivables rise 80%. It is reporting strong growth, but an increasing amount of money is being tied up in customer credit relative to its sales. Reported revenue and profits alone cannot show whether that growth is generating enough cash to support the business.

That does not necessarily mean the receivables are bad or that customers will not pay. They may simply be taking longer to pay, but the company still has to fund its employees, suppliers and other expenses while waiting for the cash.

A company can therefore show impressive growth in reported profits while generating little operating cash. That may be temporary during a period of expansion, but if the gap persists, investors need to understand why and how the company is financing it.

Nor does slower growth necessarily resolve the problem.

Sales can fall while receivables remain high or continue to increase, because the cash tied up in earlier sales does not automatically return to the business when new orders slow. Cash conversion is therefore a financial signal investors should examine before enthusiasm for growth begins to fade.

Valuation Pressure
The issue deserves particular attention in fast-growing smaller and mid-cap companies, especially those competing for large customers. A large buyer may have the bargaining power to demand longer payment periods. A smaller supplier, keen to win the order or establish a relationship, may find it difficult to insist on faster payment. In a competitive market, offering credit can become part of the sales strategy.

High market valuations can add another layer of pressure. When investors value a company on the expectation of several years of rapid growth, management faces pressure to keep delivering that growth to justify the valuation. Slower sales can lead to disappointment and greater scrutiny of the business.

That does not mean a high valuation directly causes a company to offer longer credit. Credit terms are shaped by many factors, including customer bargaining power, industry practices and the nature of the business. But high growth expectations can create an incentive to keep winning customers, even when doing so requires more working capital.

As long as growth continues and lenders or investors remain willing to provide funds, this may not immediately become a problem. The strain can emerge when growth slows, customers delay payments further or lenders become unwilling to lend more. For smaller companies, where access to capital can be limited, these changes can make rising working-capital needs harder to finance.

Reading Receivables
Even when receivables grow faster than sales, the increase may be explainable if the company has entered a new market, changed its business mix or secured large orders with longer payment cycles. Such an increase does not, by itself, establish a problem with the quality of the receivables.

The more meaningful warning sign is a persistent and widening gap between receivables growth and sales growth, particularly when accompanied by rising debtor days and weak operating cash flow. The pattern matters more than an isolated increase.

Investors should therefore compare the growth in sales and receivables, examine whether receivables are increasing as a share of revenue and check whether debtor days are rising. They should also compare operating cash flow with reported profit and establish whether the company is taking on more debt to fund working capital.

No single number provides the answer, but several of these signals moving in the same direction can reveal that reported growth is consuming more cash than investors may realise.

Investors looking for the next multi-bagger often focus on revenue growth, profit growth, margins, order books and the size of the addressable market. These are important, but they do not tell the whole story. Growth that consumes increasing amounts of cash is not the same as growth that generates increasing amounts of cash.

Fast growth is valuable only when it can eventually be converted into cash. Before celebrating the growth rate, investors need to examine how much money remains with the company’s customers and how long it can continue financing that gap. The next warning sign may be visible in unpaid invoices before it appears in rising debt.