What are Trade Receivables?

In simple words, trade receivable is the accounting entry in an entity’s balance sheet, which arises due to the selling of the goods and services on credit. Since an Entity has a legal claim over its customer for this amount and the customer is bound to pay the same, it classifies as a Current Asset in the entity’s Balance sheet. Therefore, trade receivables and accounts receivableAccounts ReceivableAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more are used interchangeably in the industry.

In simple words, trade receivable is the accounting entry in an entity’s balance sheet, which arises due to selling the goods and services on credit. Since an Entity has a legal claim over its customer for this amount and the customer is bound to pay the same, it classifies as a Current Asset in the entity’s Balance sheet. Therefore, trade receivables and account of transactionAccount Of TransactionAccounting Transactions are business activities which have a direct monetary effect on the finances of a Company. For example, Apple representing nearly $200 billion in cash & cash equivalents in its balance sheet is an accounting transaction. read more unrelated to the regular course of business.

Trade Receivables on the Balance Sheet

Below is the standard format of the balance sheetFormat Of The Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more of an enterprise.

source: Colgate SEC Filings

It is generally classified under the Current Assets in a Balance sheetCurrent Assets In A Balance SheetCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more.

Example

ABC Corporation is an electrical equipment manufacturing company. It recorded sales of USD 100 billion in FY18, with 30% sales on credit to its Corporate Customers. Accordingly, the trade receivables accounting entry for the transaction in its balance sheet will be as below:

 Accounts Receivables in the above example are calculated below:

In this example, accounts receivables will be recorded as USD 30 billion in the current asset head in the Balance Sheet. 

Why Trade Receivables is a Critical?

I will try to demonstrate why accounts receivables are very critical for the liquidity of Companies and, many a time, become the sole reason for Companies becoming bankrupt. An enterprise’s liquidity analysis comprises a company’s short-term financial positions and its ability to pay its short-term liabilities.

One of the most important metrics we look at while analyzing the liquidity positions of Companies is the cash conversion cycle. The Cash conversion cycleCash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation.read more is the number of days which an enterprise takes to convert its inventory into cash.

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The above picture explains it in more detail. For an enterprise, it starts with the purchase of inventory, which may be on cash or credit purchase. Then, the enterprise converts that inventory into finished goodsInventory Into Finished GoodsFinished goods inventory refers to the final products acquired from the manufacturing process or through merchandise. It is the end product of the company, which is ready to be sold in the market. read more and makes sales. The sales are made with cash or credit. The sales made on creditSales Made On CreditCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more are recorded as trade receivables. So the cash conversion cycle is the total number of days it takes for an enterprise to convert its inventory into final sales and cash realization.

The formula to calculate the cash conversion cycle is as below:

The above formula shows that a Company with a significantly higher proportion of trade receivables will have higher days’ receivables and, therefore, a higher cash conversion cycle.

Note: Of course, the cash conversion cycle depends on the other two factors, also which are Days inventory outstandingDays Inventory OutstandingDays Inventory Outstanding refers to the financial ratio that calculates the average number of days of inventory held by the company before selling it to the customers, providing a clear picture of the cost of holding and potential reasons for the delay in the inventory sale.read more and Days payables outstanding. However, here to explain the impact of receivables, we have kept the other two parameters indifferent.

A higher cash conversion cycle for an enterprise may lead to a significantly increased working capital loanWorking Capital LoanA working capital loan is a loan taken out by a company to finance its day-to-day operations, such as funds to cover the company’s operational needs for a short period of time, such as debt payments, rents, or payroll, rather than for long-term investments or assets.read more requirement to meet its short-term demand for day-to-day operations. Once such receivables level reaches an alarming degree, it may create serious trouble for the enterprise creating short-term liquidity issues where the company will not be able to fund its short-term liabilities, which may further lead to suspending the company’s operations.

Essential Part of Working Capital Loan Assessment

A company avails working capital loans to meet its short-term requirements for day-to-day operations. The amount of working capital limit is assessed by lenders taking all the company’s current assets into account. Since receivables make an essential and considerable part of the company’s total current assets, lenders must assess the level of trade receivables and the quality of receivables to approve working capital limits for the company.

Analysis and Interpretation

The liquidity analysis and interpretation for the level of trade receivables should always be looked into in the specific industry context. Certain industries operate in an environment with a high level of receivables. A typical example is electricity generation companies operating in India, where receivables are very high and days receivable for generation companies vary between as low as one month to as high as nine (9) months.

On the other side, some companies operate with virtually very few or no trade receivables. For example, companies operating and toll road project developers and operators have fewer accounts receivables as their revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more is toll collection from commuters on the road. They collect the toll from commuters as and when they pass by toll plaza.

So for a meaningful analysis, one should look at the receivables levels of the top 4-5 companies in the respective industry. For example, suppose your target company has higher receivables in comparison. In that case, it is doing something wrong either in the business model or client/customer targeting or incentives in terms of credit sales to promote sales.

To conclude, one can safely assume that the lower the receivables level and days receivables, the better the liquidity position for the company.

Trade Receivables Video

This has been a guide to Trade Receivables. Here we discuss its definition, how it works. Examples and see why trade receivables are critical for the liquidity of companies. You can learn more about accounting from the following articles –

  • Accounts Receivable Turnover
  • Accounts Receivables Factoring
  • Accounts Receivable vs. Accounts Payable