What are Trade Receivables and How to Calculate Them?

What Are Trade Accounts Receivables?

Trade receivables represent what customers owe a business for provided goods or services, also known as accounts receivable. This falls under current assets on a balance sheet, reflecting the company’s outstanding payments. Efficient management of trade receivables is crucial for maintaining healthy cash flow.

Most B2B businesses offer goods and services to customers on credit. Trade receivables is the amount that customers owe to a business when buying a product or service on credit. It is a key line item in the balance sheet and is listed under the current assets section due to its short conversion time into cash.

Trade receivables are called so because they arise from business trade deals between the company and a customer. A company’s balance sheet also has non-trade receivables, which make up the amount they will receive from other sources like tax rebates, refunds, insurance claims, and so on.

How to calculate trade receivables with a formula?

A business can calculate its trade receivables by summing up the amount that all its customers owe them. It is generally divided into two parts called debtors and bill receivables.

Trade Receivables = Debtors + Bill Receivables

Bill receivables are a formal agreement between a customer and the business agreeing to pay a certain amount within a particular period for the goods or services they receive. On the other hand, debtors are the bill receivables that remain unfulfilled on the due date.

Example of trade receivables

Company XYZ has bill receivables worth $150,000 and debtors worth $35,000 on its balance sheet. It also has an annual revenue of $750,000.
Trade receivables = Debtors + Bill Receivables
= $35,000 + $150,000
= $185,000
So, the total trade receivables of Company XYZ is $185,000.

Why are trade receivables essential?

Trade receivables as a standalone metric don’t tell much about a business’s financial position. However, we can calculate the days sales outstanding (DSO) of a business with the trade receivables and annual revenue figures. 

DSO is indicative of a business’s ability to collect payments on time. Comparing it with the industry average DSO can help conclude if the business has a good cash flow or not. 

A business’s DSO must be as close to the industry average as possible if it wants to perform well. A low DSO is always preferred, but the business might be losing out on potential customers due to stringent credit terms if the DSO is too low. On the contrary, a high DSO means poor cash flow and low working capital.

Calculating DSO with trade receivables and interpreting it

Let’s continue with the example from above. We found that the trade receivables for Company XYZ is $185,000, and they have annual revenue of $750,000. 

DSO = (trade receivable/ annual revenue)*365

= (185,000/750,000)*365

=0.246*365

=89.79 ≈ 90 days

So, the DSO of company XYZ is 90 days.

Now, let’s say that Company XYZ is in the petroleum refining industry that has an average DSO of 25 (Source); then, comparatively, its DSO is very high and needs to be reduced. However, if it is in the building construction industry, then their 90 days DSO is very close to the industry average of 83, which is good.

What is trade receivable financing?

Trade receivables are an asset for a company. But if a business is not cash-rich and needs funds immediately for any reason, it can opt for trade receivables financing. Trade receivable financing allows businesses to raise funds against the invoices that customers owe them.

For example, let’s say company A receives an order to produce 100,000 chocolate bars for $800,000 which will be paid within 45 days by the customer. However, to produce the order, company A needs to procure raw materials, for which it needs capital. So, company A can use trade receivables financing to raise funds and fulfill the order.

Primary ways to finance trade receivables

There are two main ways by which a company can finance its trade receivables. They are:

1. Invoice Discounting: In this method, a company sells its invoice(s) at a discount (generally 90%) to a third party and receives the money. So, when the customer pays for the order, it goes to the third party that purchased the invoice. In this case, the company is responsible for collecting the payment and paying the buyer of the invoice(s).
2. Factoring: It is similar to invoice discounting, but the invoices sell for much lower (70%-90%). In factoring, the third party, called the ‘factor’, buys the invoice and is responsible for collecting the payment on behalf of the company. On receiving the payment, the factor takes their fee and sends the remaining amount to the company.

FAQs

1) Is trade receivables an asset or liability?

Trade receivables fall under current assets on a balance sheet because they are expected to convert into cash in less than a year.

2) What are non-trade receivables?

Non-trade receivables are also assets, but as the name suggests, it doesn’t arise from the sale of goods or services. For example, insurance payouts or tax rebates on a balance sheet will fall under non-trade receivables until they are converted to cash.