Most business leaders have a pretty good handle on what accounts receivable is. Many organizations even have a dedicated person or department to handle AR.
But what about other kinds of receivables? Specifically, what about trade receivables? What are those, and how do they work?
If you’re like many business leaders, you might not have even known that trade receivables are a thing.
In this guide, we’re going to shed some light on the concept of trade receivables.
We’ll provide a basic definition of what trade receivables are, explain how they are recorded in financial accounting, and discuss their importance and role in capital management.
What is a trade receivable?
Definition of trade receivable is an amount owed to a business by customers for goods or services provided on credit.
Sounds like accounts receivable, right?
That’s because trade receivables are a subset of accounts receivable. Accounts receivable represents all money owed to the business, which is essentially broken down into two categories:
- Trade receivables
- Non-trade receivables
The distinction relates to whether the amount owed relates to core business activities or not. If your business sells tires, for example, then any sales of tires on credit would be a trade receivable, as it relates to your core business activity.
But money owed to you from your insurance company, while still receivable, is categorized as a non-trade receivable since it’s not related to core business operations.
Trade receivables are considered current assets on the balance sheet since they are generally expected to be converted into cash within one year.
Types of trade receivables
It’s possible to break trade receivables down further into two subcategories:
- Trade accounts receivable: Amounts due from customers for sales made on credit
- Trade notes receivable: Formal agreements and promissory notes signed by customers with an agreement to pay a specific amount by a certain date
In practice, however, we rarely go to this level of detail. Even on the balance sheet, receivables are almost always only listed as accounts receivable, which may be made up of both trade and non-trade receivables.
How trade receivables are recorded in accounting
Trade receivables are initially recorded when a credit sale is made, and are entered into the journal as accounts receivable.
For instance, if a company makes a $5,000 sale on credit, the following journal entries would be made:
- Debit: Accounts receivable
- Credit: Revenue
From there, the handling of trade receivables depends on what happens to the owing amount. If the customer pays their bill, then the journal entries are:
- Debit: Cash
- Credit: Accounts receivable
If we have to write the account off as a bad debt, however, because the customer doesn’t pay, then our journal entries look like this:
- Debit: Bad debt expense
- Credit: Accounts receivable
Calculating trade receivables
You can calculate trade receivables based on the amount owed by customers for credit sales at a specific point in time.
The formula you’ll apply depends on whether you’re working with gross receivables or net receivables (adjusted for doubtful debts).
Formula to calculate trade receivables
The two formulas used to calculate trade receivables (depending on whether you’re calculating gross or net receivables) are:
Let’s use an example to illustrate.
Say a company has the following data for a given period:
- Opening receivables: $10,000
- Credit sales: $50,000
- Collections during the period: $40,000
- Allowance for doubtful accounts: $2,000
First, we’ll calculate gross trade receivables:
$10,000 + $50,000 - $40,000 = $20,000
Then, if we wish to calculate net trade receivables, we apply the second formula:
$20,000 - $2,000 = $18,000
Factors influencing the calculation
Many factors influence what your total trade receivables balance is at any given time.
The most common to bear in mind include:
- Credit sales volume. If you make more sales on credit, you’ll increase trade receivables.
- Collection efficiency. The faster you’re able to collect on outstanding accounts, the lower your receivables will be.
- Credit terms. Longer payment terms naturally lead to increased trades receivable amounts.
- Allowance for doubtful accounts. If you’ve made allowances for accounts you don’t think you’ll receive payment for, this will reduce your net receivables.
- Seasonality. Some industries may see fluctuating trade receivable balances when comparing month on month due to seasonal sales patterns.
Trade receivables turnover ratio
Many financial leaders want to know how efficiently a company collects on its receivables, and they use the trade receivables turnover ratio to do that.
It's a great metric to track if improving cash flow from credit sales is a priority. Here’s what the formula looks like:
Trade receivables turnover ratio = Net credit sales / Average trade receivables
To make that calculation, you first need to know your:
- Net credit sales: Total sales made on credit for the period
- Average trade receivables: (Opening receivables + Closing receivables) / 2
Let’s walk through an example to illustrate.
Say a business has made a total of $100,000 in credit sales over the last 12 months. At the beginning of the financial period, trade receivables were $10,000. At the end of the period, they were $20,000.
First, we calculate the average trade receivables: ($10,000 + $20,000) / 2 = $15,000
Then, we can apply the trade receivables turnover ratio:
$100,000 / $15,000 = 6.67
So, what does that mean?
It means that the company collects its outstanding receivables approximately 6.67 times a year. It is often helpful to put that in the context of how many days it takes to collect, for which we apply the formula:
365 / 6.67 = 54.75 days
Thus, it takes this company around 55 days to collect cash from sales made on credit.
Generally speaking, higher turnover ratios (fewer days) indicate efficient collections, while lower ratios (more days) can signal collection or credit policy issues.
Importance of trade receivables
Understanding how to trade receivables work is especially important for businesses that regularly operate on credit terms.
They help finance and businesses with:
- Revenue recognition. Trade receivables represent revenue earned but not yet received in cash, allowing businesses to track income and financial health accurately.
- Monitoring liquidity. Trade receivables are an important part of current assets and tell us about the short-term liquidity position of the company, especially when considered in conjunction with the turnover ratio.
- Business growth. Extending credit terms can often be a powerful tool for encouraging larger purchases from customers, helping to grow sales, revenue, and market share.
Role of trade receivables in working capital management
Trade receivables play a number of critical roles in managing a company’s working capital. Here's how:
Maintaining cash flow
Trade receivables directly affect cash inflows. Delayed collections can strain cash flow and cause operational problems. Efficient collections processes ensure funds are available for key activities like operating expenses, inventory purchase, and debt servicing.
Optimizing the Cash Conversion Cycle (CCC)
The cash conversion cycle (CCC) measures the time it takes to convert investments in inventory and other resources into cash. Shortening the trade receivables turnover period reduces the CCC, enhancing liquidity.
Balancing credit risk and sales growth
Extending credit to customers can boost sales, but it also comes with the risk of bad debts.
Effective management of trade receivables helps balance these two important goals.
Capital allocation
Reducing the amount of time that trade receivables remain outstanding minimizes the need to rely on external financing.
This frees up capital for other investments and reduces interest expense.
Factoring trade receivables
Factoring trade receivables is a financial arrangement where a business sells a receivable to a third-party company, known as a factor, in exchange for immediate cash.
Instead of having to wait for your customer to pay, you receive the money now, and the third-party factoring company assumes responsibility for chasing up the payment from the customer.
For instance, imagine you have $50,000 in trade receivables due from a customer in 30 days, but you need that cash now. You could sell those receiving to a factoring company for $45,000. They take a 10% fee, so you “lose” $5,000, but you benefit from receiving the cash now.
This approach can be provide some important benefits for working capital management, including:
- Improving liquidity
- Reducing collection risk
- Mitigating credit risks
- Accelerating the Cash Conversion Cycle (CCC)
- Supporting growth and scalability
Improving trade receivables management with BILL
Keeping on top of trade receivables is an important focus for many business leaders.
To maximize efficiency, turn to an accounts receivable automation platform like BILL. With BILL, you can:
- Automate invoicing
- Manage customer follow–ups more efficiently
- Receive payments right in your bank account by ACH or credit card
FAQ
Is trade receivables an expense?
No, trade receivables are not an expense.
Instead, trade receivables are included as a current asset on the balance sheet. However, you won’t typically see them listed specifically but rather included as part of your company’s accounts receivable.
What are non-trade receivables?
Non-trade receivables are amounts owed to a business that are not related to its primary operations or sales activities.
Some classic examples of non-trade receivables include:
- Loans or salary advances given to employees
- Overpaid taxes owed back by the government
- Payments due from insurers for an approved claim
- Dividends or interest due from investments or loans
While trade receivables arise from sales, non-trade receivables stem from secondary or incidental transactions.
What’s the difference between trade receivables and trade payables?
Trade receivables are money owed to your business by your customers for sales made on credit. Trade payables are money that your business owes to its suppliers for purchases you’ve made on credit.
How can you reduce trade receivables?
Here are 7 powerful strategies you might consider implementing to reduce trade receivables and improve cash flow:
- Revisit your credit policies and establish penalties for late payments
- Incentive early payments with discounts
- Automate invoicing and reminders
- Evaluate customer creditworthiness before making credit sales to reduce defaults
- Follow up early and regularly on overdue accounts
- Outsource difficult-to-collect accounts to a third-party collections agency
- Sell receivables to a factoring company for immediate cash, known as trade receivables financing
What is trade receivable financing?
Trade receivable financing, which is more commonly referred to as invoice financing, is a financial arrangement where a business sells its receivables to a lender or factoring company at a discount in exchange for immediate cash.
Say, for instance, you have a customer with a $10,000 outstanding account. You sell it to the factoring company for $8,000 and receive that cash immediately.
They then assume responsibility for collecting that payment from the customer and benefit from the potential upside of receiving the entire amount.
