Trade receivables are defined as the amount owed to a business by its customers following the sale of goods or services on credit. Also known as accounts receivable, trade receivables are classified as current assets on the balance sheet.
Current assets are assets which are expected to be converted to cash in the coming year. In addition to trade receivables, current assets also include items such as cash, cash equivalents, stock inventory and pre-paid liabilities.
A company’s receivables may include both trade and non-trade receivables, with the latter including receivables which do not arise as a result of business sales, such as tax refunds or insurance payouts. Non-trade receivables are also typically recorded on the balance sheet as current assets.
Trade receivables, or accounts receivable, are the opposite of accounts payable, which is the term used when a company owes money to its suppliers or other parties.
Trade receivables example
To give an example of trade receivables, a company might invoice its customer $475 for the sale of materials. Under double entry accounting principles, the company will credit the sales account by $475 while also debiting the trade receivables account by the same amount. Once the customer has paid the bill, the company will credit the trade receivables account by $475 and debit the cash account.
Trade receivables and working capital
A company’s trade receivables or accounts receivable is an important consideration when it comes to calculating working capital. Working capital is calculated as current assets minus current liabilities, with current assets including accounts receivable and inventory as well as cash and equivalents, and current liabilities including accounts payable.
Where working capital is concerned, one significant metric is Days Sales Outstanding (DSO), which is defined as the time taken for a company to receive payment from customers after selling goods or services. A lower DSO is preferable, as the faster an invoice is paid, the sooner the seller can make use of cash.
However, the other side of this equation is the buyer, who may wish to extend payment terms in order to increase their Days Payable Outstanding (DPO). This can result in a higher DSO for suppliers, which may not receive payment for 60 or 90 days in some cases.
Financing trade receivables
When a company sells goods on credit, it has to pay for raw materials weeks or even months before receiving payment for the sale from its customers. This can lead to cash flow constraints and make it difficult to fulfil customer orders or invest in business growth and research and development (R&D). As such, companies may choose to finance their trade receivables – in other words, seek early payment in exchange for a discount.
Companies can achieve this in a number of different ways, including the use of AR finance and receivables finance solutions. Factoring, for example, enables a company to sell its invoices to a factor at a discount, thereby receiving a percentage of the value of an invoice straight away. The factor will then be paid by the company’s customers at maturity. However, this can be an expensive funding option.
Similar to factoring is invoice discounting, in which an invoice discounter advances a percentage of the value of an invoice. Unlike factoring, invoice discounting allows the seller to retain control over its sales ledger while remaining responsible for collecting payments from customers.
Another option is asset-based lending (ABL), in which companies can access a line of credit, with funding secured against assets such as accounts receivable. ABL can also be structured around other assets such as commercial property, equipment or inventory.
Early payment programs
Companies can also receive early payment if their customers give them access to early payment programs such as supply chain finance or dynamic discounting. These are initiated by the buyer rather than the seller and tend to provide funding at a lower interest rate than methods such as factoring.
Early payment programs can provide considerable flexibility when it comes to choosing which invoices to finance. This type of solution also gives sellers more certainty about the timings of future payments, making it easier to forecast cash flows effectively.
Accounts receivable department
As well as referring to trade receivables, the term ‘accounts receivable’ is also used to mean the team within the organization which is responsible for collecting payments from customers.
As such, accounts receivable will carry out activities such as generating and sending invoices, monitoring invoice due dates and chasing overdue payments from customers. Accounts receivable may also carry out receivables analysis to understand the payment behavior both of the customer base as a whole, and of specific debtors.
In cases where customers do not pay their invoices by the maturity date, accounts receivable will be responsible for chasing customers, with actions ranging from letters and phone calls to initiating legal action and engaging external debt collection agencies.