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What are Trade Receivables?

What are Trade Receivables?

Trade Receivables Definition

Trade receivables, often referred to as accounts receivable, are amounts owed to a business by its customers for goods or services delivered or used on credit, but not yet paid for. Essentially, when a company sells something to a customer and allows them to pay later, this creates a receivable on the company's balance sheet.

Financial accounting software, such as an accounts receivable automation solution, can help with trade receivables management.

Trade Receivables Calculation

Calculating trade receivables is typically a straightforward process, but it involves understanding various components of a business's sales and collections activities. Here's a basic guide to calculate trade receivables:

  • Start with the Beginning Balance: At the start of an account period (like the beginning of a month or a year), you'll have an opening balance of trade receivables. This is the amount of receivables carried over from the previous period.
  • Add Credit Sales: Throughout the accounting period, the company will probably make sales on credit. Add total credit sales to the opening balance of trade receivables. These sales are usually recorded in the subledger.
  • Subtract Cash Collections: Over the same period, the company will collect payments from customers against the credit sales made in the past. Subtract the total amount collected from customers from the sum of the opening balance and credit sales. This includes any payments made for sales in the current period and outstanding sales from previous periods.
  • Adjust for Return and Allowance: If there are any sales returns or allowances (like discounts given to customers or adjustments for defective goods), these amounts should be subtracted from the total.
  • Consider Bad Debt: If any receivables are identified as uncollectible during the period (overdue invoices), they should be written off and subtracted from the total receivables.
  • Cash Application: Cash application is matching incoming payments to a corresponding invoice. It is a critical step in the accounts receivable process because it ensures that payments are accurately recorded and that the business's financial records reflect the correct status of the customer receivable account.
Ending Trade Receivables = Opening Balance + Credit Sales − Cash Collections − Sales Returns and Allowances − Bad Debt Write-offs

Trade Receivables Example

Let's go through an example to illustrate how to calculate trade receivables.

Suppose a company, ABC Corp, has the following trade finance figures for a particular month:

  1. Opening Balance of Trade Receivables: $20,000 (This is the amount of receivables carried over from the previous month).
  2. Credit Sales for the Month: $50,000 (Sales made on credit during the current month).
  3. Cash Collections from Customers: $30,000 (Payments received from customers for previous and current credit sales).
  4. Sales Returns and Allowances: $2,000 (Customers returned goods or received allowances for certain issues).
  5. Bad Debt Write-offs: Bad debt of $1,000 (Doubtful accounts (irrecoverable debt) identified and written off during the month).

Plugging in the numbers:

Ending Trade Receivables = $20,000 + $50,000 − $30,000 − $2,000 − $1,000

The ending trade receivables for ABC Corp. for that month would be $37,000. This amount represents the total receivables that the company expects to collect from its customers in future periods, considering the transactions that occurred during the current month. ​

Non Trade Receivables

Non-trade receivables are amounts owed to a business that is not related to the sale of goods or services. These can include loans to employees, advances to suppliers, tax refunds, insurance claims, and deposits paid for utilities or rent. Unlike trade receivables, which arise from a company's regular business operations, non trade receivables are typically one-off or irregular transactions.

Importance of Trade Receivables

Trade receivables play a significant role in the financial and operational aspects of a business. Their importance can be outlined in several key areas:

  • Cash Flow Management: Trade receivables are a critical component of a company's cash flow. They represent future cash inflows from credit sales. Effective management of trade receivables ensures that a company has enough cash on hand to meet its short-term obligations and invest in growth opportunities.
  • Revenue Generation: Offering products or services on net terms can significantly increase a company's sales. Many customers prefer to buy on credit, especially in B2B transactions. This flexibility can attract more customers and lead to increased revenue.
  • Liquidity: Trade receivables are liquid assets, meaning they can be quickly converted into cash (usually within one year). This liquidity is essential for maintaining the day-to-day operations of a business.
  • Credit Management: The management of trade receivables involves assessing the creditworthiness of customers, setting credit limits, and monitoring outstanding balances. This helps in mitigating the risk of bad debt and maintaining a healthy balance between sales growth and credit risk.
  • Customer Relationships: Extending credit to customers can help build long-term relationships. It shows trust and can lead to repeat business, larger orders, and customer loyalty.
  • Financial Indicators: Trade receivables are a key component of various financial KPIs and metrics, such as the accounts receivable turnover ratio. These ratios are used by management, investors, and creditors to assess the financial health and efficiency of a business, particularly in terms of how effectively it manages and collects its receivables and identifies any debtor and act proactively.
  • Working Capital Management: Trade receivables are a significant part of working capital. Effective management of trade receivables, along with inventory and payables, is crucial for maintaining a healthy working capital cycle, ensuring the business has enough capital to fund its operations and growth.

Receivable Financing

Trade receivable financing, also known as accounts receivable financing, is a financial arrangement where a business uses its trade receivables (i.e., the money owed by customers for goods or services delivered on credit) as collateral to secure financing. 

This type of financing is a way for businesses to improve their cash flow and access working capital without waiting for their customers to pay their invoice. Here's how it typically works:

  • Invoice Issuance: A business sells goods or services to its customers on credit and issues invoices with payment terms (e.g., 30, 60, or 90 days).
  • Financing Agreement: The business then approaches a financial institution or a specialized financing company and an agreement to use these outstanding invoices as collateral for a loan.
  • Funding: The financing company provides a percentage of the total invoice value to the business upfront. This percentage varies but is typically between 70% and 90% of the invoice value.
  • Customer Payment: The customers of the business pay their invoices directly to the financing company according to the payment terms.
  • Receiving the Balance: Once the financing company receives the payments from the customers, it remits the remaining balance of the invoices to the business, minus any fees or interest charged for the financing service.

There are two main types of trade receivable financing:

  • Factoring: In this arrangement, the financing company actually purchases the receivables from the business. Factoring (financing company) takes on the responsibility of collecting payments from the customers. The business receives a lesser amount than the total value of the invoices, as the factor holds a fee for their service.
  • Invoice Discounting: With discounting, the business holds control over its sales ledger and collects payments from its customers. The financing company provides a loan based on the value of the receivables, and the business repays the loan plus interest and fees once it collects the payments.

Trade receivable financing is beneficial for businesses that have long invoice-payment cycles or need immediate cash flow to meet operational expenses, invest in growth opportunities, or manage seasonal demand fluctuations. However, it's important to consider the costs and terms of such financing, as the fees and interest rates can vary significantly.

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