What is Trade Receivables?
Trade receivable is the amount which the company has billed to its customer for selling its goods or supplying the services for which the amount has not been paid yet by the customers and is shown as an asset in the balance sheet of the company.
In simple words, trade receivable is the accounting entry in the balance sheet of an entity, 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 Current Asset in the Balance sheet of the entity. Trade receivables and accounts receivable are used interchangeably in the industry.
Similar to accounts receivables, Company’s also have non-trade receivables, which arises on account of transaction unrelated to the regular course of business.
Trade Receivables on the Balance Sheet
Below is the standard format of the balance sheet of an enterprise.
source: Colgate SEC Filings
It is generally classified under the Current Assets in a Balance sheet.
ABC Corporation is an electrical equipment manufacturing company. It recorded a sales of USD 100 billion in FY18 with 30% sales on credit to its Corporate Customers. The trade receivables accounting entry for the transaction in its balance sheet will be as below:
Accounts Receivables in the above example is calculated below:
In this example, accounts receivables will be recorded as USD 30 billion in the current asset head in the Balance Sheet.
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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 becomes the sole reason for Companies becoming bankrupt. The liquidity analysis of an enterprise comprises of 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 cycle is the number of days which an enterprise takes to convert its inventory into cash.
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. The enterprise converts that inventory into finished goods and makes sales out of it. The sales are made or cash or credit. The sales made on credit is 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 realization of cash.
The formula to calculate the cash conversion cycle is as below:
From the above formula, it is evident 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 outstanding 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 loan requirement to meet its short-term demand for day to day operations. Once such receivables level reaches the 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 and which may further lead to suspending operations of the company.
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 assessment for the amount of working capital limit is carried out by lenders taking into account all the current assets of the Company. Since receivables make an essential and considerable part of the total current assets of the Company, it is critical for lenders to access the level of trade receivables as well as 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 context of the specific industry. Certain industries operate in an environment with a high level of receivables. A typical example of the same is electricity generation companies operating in India, where receivables level are very high and days receivable for generation companies varies 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. Companies operating and toll road project developers and operators have very fewer accounts receivables as their revenue 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. If your target company has higher receivables in comparison, than it is doing something wrong either in terms of business model or client/customer targeting or incentives in terms of credit sales to promote sales.
To conclude, one can safely assume that lower the receivables level and days receivables, 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 –