Buyers often settle invoices after a significant period of time from when they receive their goods. In some cases buyers need goods or services on an urgent basis but don’t have the liquidity required for purchase.
At such times, the seller transfers the ownership of the goods to the buyer on credit. In both these situations, the buyer owns the goods, but the seller is still owed the amount. This amount is considered as trade receivables by the seller.
Meaning
Trade receivables refers to the amount that is yet to be paid by customers after purchasing goods or services from a business. They are classified as current assets on the balance sheet. As an important yardstick of a business's future growth, trade receivables are used to create accurate accounting reports every financial year. They also help a business take pre-emptive action to maintain a steady flow of capital in case they foresee any cash flow crunches. From a perspective of third parties, trade receivables are vital to understand how reliable and established a business is.
Accounting For Trade Receivables
Trade receivables are recorded in the balance sheet under a separate accounts receivable account. It is classified as current assets if the buyer's payment is expected within one year of the billing date. For example, XYZ has issued an invoice to their buyer of INR 5000 for the sale of certain articles.
Using the double entry principles for accounting, XYZ will credit or decrease the value of their sales account by INR 5000 and debit or increase the trade receivables account by INR 5000. Once the buyer has settled the invoice, XYZ will subtract INR 5000 from their trade receivables and add the same to the cash account.
Importance
The importance of using and showcasing trade receivables are -
- Indicates Revenue Growth
One advantage of recording trade receivables is that it represents an amount of money that is expected to flow into the company. Therefore, it helps to give an indication of the business's potential for earning revenue.
- Helps Address Cash Flow Issues
A company can face potential issues with their cash flow if some customers do not pay within the specified term. If a business forgets to record their receivables, it can have a negative impact on their ability to generate cash flow. Therefore, monitoring receivables is imperative because it can allow the company to take immediate action if the bill is not settled within the payment period.
- Showcases Credibility
Tracking receivables regularly helps to generate accurate accounting reports at the end of a financial year. The report is examined by creditors, investors, and various stakeholders to evaluate a company's financial performance and creditworthiness. Hence, recording trade receivables makes a firm appear more attractive and reliable to third parties.
Contents of Trade Receivables
Trade receivables, also known as account receivables, comprise all the invoices billed for goods or services that have been sold or delivered to the customers but are yet to be paid.
They are generally the biggest asset on many companies’ balance sheets as they represent all the money outstanding and due to be received by the company shortly.
Calculation of Trade Receivables Calculation of trade receivables is done by using the following
Trade Receivables Formula
Trade Receivables = Debtors Receivables + Bills Receivables
Example A company, XYZ, sold goods worth INR 30,000 on credit to ABC. XYZ showcases this amount in their balance sheet along with their other pending bills receivable worth INR 20,000. XYZ regularly checks its balance sheet and wants to calculate its trade receivables. To do so, it adds INR 30,000 + INR 20,000 which gives a total amount of INR 50,000 in trade receivables.
After calculating their trade receivables, the management at XYZ wants to estimate how long it takes for them to receive payments on their trade receivables. If the total revenue of XYZ yearly is INR 150,000, the calculation done for this is as follows:
Trade Receivable Days = (Trade receivables/Annual Revenue) x 365 days = (INR 50,000 / INR 150,000) x 365 days = 121.66
This provided them with an estimate of about 121 days to collect their typical invoices.
Financing Trade Receivables
When a seller sells the goods or services on credit, they have to pay for various factors, such as raw materials, months before receiving their payment from the sale. As this causes a hindrance to their cash flow, sellers can choose to fund their trade receivables by seeking early payment in exchange for a discount. They can finance their invoices using various methods such as factoring, line of credit, invoice discounting, among others. Another way they can seek early payment is if the buyer gives them access to programs such as dynamic discounting and supply chain finance. These solutions provide more flexibility and a lower interest rate. They also offer sellers more certainty about when they will receive their future payments and enable more accurate cash flow forecasts than other methods.
How to Reduce Trade Receivables
Providing Multiple Payment Options To encourage the buyers to pay on time, a seller should give their clients various payment options. Buyers may like to pay using cash, credit cards, cheques, or online payments, and keeping all these options open for them to choose from attracts them to the seller’s company.
Implementing Early Payment Incentive and Late Payment Fees To prompt buyers to pay on time, a seller can provide incentives for early payments. However, if a buyer is late in their payment, the seller should impose late payment charges. Implementing both options should be an incentive for the buyers to pay early or on time.
Sending Invoices Instantly As soon as the service is provided or the ownership of goods is transferred on credit, the seller should send the invoice to the consumer. The longer the seller takes to issue the bill, there will be a delay in receiving the payment.
Sending Reminders Certain consumers are irresponsible when it comes to paying the bill, which is a problem for sellers. To ease this situation, the seller can send email reminders to the buyer, reminding them of their payment agreement.
Requesting Partial Advance Payment If the goods being sold are costly or the project the seller is working on is of a long duration, then requesting a partial advance payment is a solution the seller should look into. This helps to prevent the risk of not getting the bill settled.
Reducing Payment Period The invoice payment term can vary in different industries. It is, therefore, important to keep the payment term short. The shorter the payment term, the faster the bill is paid, improving the cash flow.
Calling the Client If the buyer ignores and neglects all the payment reminders issued by the seller, then the seller can always call the client and have a conversation regarding the delayed payment.
Difference Between Trade Receivables and Non-Trade Receivables
Trade receivables are the amount due to the seller on the sale of goods or services to the buyer on credit. Non-trade receivables are also an asset that signify money still owed to the seller but from methods other than selling products or inventory. Sources of non-trade receivables include interest payments, dividends, insurance claims, etc.
FAQs
What is the difference between trade receivables and accounts payables? Trade receivables are the amount owed by buyers to sellers on credit. In contrast, accounts payable is when the seller owes an amount to their vendors for purchasing products, services, or inventory. Also, trade receivables are accounted for under current assets, whereas account payables are classified as current liabilities.
What is an aging schedule for accounts receivable? Accordi/ng to the due dates, an aging schedule outlines a company’s trade receivables. Essentially, it helps to showcase a breakdown of the receivables by the timeline of an outstanding invoice, the amount due, and the corresponding buyer name.
What is an allowance for doubtful accounts? A doubtful account is a contra-asset that directly affects trade receivables. It calculates the trade or account receivables that might turn into bad debt. Suppose a buyer refuses to pay; cash can be withdrawn from this account. If all your clients do pay on time, then the need to use this allowance may never arrive. It is, however, a good practice for companies to set aside an allowance for doubtful accounts.
Can trade receivables be shown as negative? A negative account receivables balance need not be seen as impacting cash flow. Sometimes it can be due to overpayment by the customers.
What causes account receivables to increase? If a company's balance sheet shows an increase in accounts receivable, this means that the revenue earned through the payment on credit is high. The company, therefore, has more cash payments to collect in the future.
