Trade receivables are one of the components of the balance sheet's current assets due to high liquidity. The subject of purchase on credit can be not only goods but also services. They arise when a company sells its products or services with prolonged payment date. Until the moment of payment, a record in trade receivables will be visible in the selling enterprise's balance sheet, equal to the value of the items or services sold, for which the customer has to pay. It means that trade receivables are the amount of money which has to be paid by the client who did not settle it in a given period of time. Trade receivables are created when the company allows a client to buy on credit. The credit time is the special period when a client should settle his debt arising from the enterprise. The given time depends on a relation between both of the engaged parties or the financial condition of the buyer. Usually, the time given to settle the debt is:
- 30 days,
- 60 days,
- or 90 days.
Bad Debt recognition
The selling company also performs aging procedures on trade receivables, which shows how many days the invoices have not been paid. Usually, if the debt has not been paid for a year (depends on the company's policy), this amount of trade receivables become overdue and has to be recognized as a cost. This amount becomes, so called “Bad Debt” and is subtracted from the balance sheet's current asset position and added to the cost section in profit & loss financial document.
Factoring business model
Settlement of bills by the client in a specific time gives the company the opportunity to better manage company's finances. On the other hand, the need of financial liquidity developed a type of business called “Factoring companies”. This business model focuses on purchasing trade receivables from the enterprises by external party – not involved in the transaction process between the buyer and the seller - for a lower price than its value. This option is used when an enterprise is at risk of losing financial liquidity. The factoring company earns on the difference between the amount of collected debt and the amount paid for the trade receivables. However, it also must bear the risk of uncollected debt. Thus, the company which sells its trade receivable to the factoring company also reduces the risk connected with bankruptcy or dishonesty of their customer which is a desirable phenomenon. If the enterprise is not at risk of losing financial liquidity, it is also important to control all of the trade receivables to accordingly react if necessary. However, the company should be patient towards its customers. Excessive haste and pressure to pay off debts can ruin the relation between the company and the client.
Examples of Trade receivables
- The first example of trade receivables is the sale of goods and services with a set payment date. This type of receivable is commonly used for purchases of goods and services that are not immediately paid. For instance, a customer purchases a car from a car dealership and is given a set payment date of 30 days from the date of purchase. The dealership will then record the transaction as a trade receivable and the customer will owe the dealership the full purchase price.
- The second example of trade receivables is a loan. This type of receivable is often used when a company needs to borrow money from a lender. The loan will be recorded as a trade receivable and the company will be responsible for repaying the loan, with interest, by the end of the agreed upon term.
- The third example of trade receivables is when a company provides a service to a customer and allows them to pay at a later date. This type of receivable is usually used for services that require immediate payment, such as consulting services or website design services. The company will record the transaction as a trade receivable and the customer will be responsible for paying the agreed upon amount by the end of the payment term.
- The fourth example of trade receivables is when a customer purchases goods or services from a company using a credit card. In this situation, the company will record the transaction as a trade receivable and the customer will be responsible for paying the full amount plus any applicable interest or fees by the end of the payment term.
Advantages of Trade receivables
Trade receivables provide many advantages for businesses. They are an effective way to expand the customer base and increase sales, as well as providing a source of additional working capital. Below are some of the advantages of trade receivables:
- Increased sales: Trade receivables allow businesses to offer customers the option to purchase goods or services on credit, resulting in an increase in sales. This can help businesses reach new customers and increase their customer base.
- Improved cash flow: Trade receivables provide businesses with a source of additional working capital. Once the customer pays their invoice, the company will receive a cash inflow that can be used to cover expenses or invest in other areas of the business.
- Flexibility: Trade receivables provide businesses with flexibility in how they manage their finances. They can use trade receivables to structure payment terms for customers and make it easier for them to pay their invoices.
- Improved relationships: By offering trade receivables, businesses can build trust with their customers and develop strong relationships. Customers are more likely to return if they know that they can rely on the business for flexible payment terms.
Limitations of Trade receivables
- Trade receivables are subject to potential bad debts, which can result in a significant financial loss for the company as the debtors may not pay their liabilities.
- There is a risk of maintaining too much credit, as the company may be unable to collect its receivables, and thus, lose money due to the uncollectible debt.
- Trade receivables can be difficult to manage, as it requires a lot of resources and effort to keep track of all the different accounts and the payment terms for each of them.
- Management of trade receivables can be a time-consuming process, as it requires the company to monitor payment terms, terms of credit, and customer account information.
- Trade receivables also have an impact on the company's cash flow, as the company has to wait until the customer pays their debt, which can lead to cash flow problems if the customer is late in making payments.
- One approach to managing trade receivables is to incentivize customers to pay early, such as offering discounts for on-time payments.
- Another approach is to set up a payment plan with customers, such as allowing customers to make payments in installments.
- A third approach is to set up a direct debit system where customers can pay their bills automatically.
- A fourth approach is to use collections agencies to pursue delinquent accounts.
In summary, there are several approaches to managing trade receivables, such as offering discounts for early payments, setting up payment plans, setting up a direct debit system, and using collections agencies. Each approach has its advantages and disadvantages and should be carefully considered before implementation.
- ↑ A. Harssan Gorondutse, R. Abass Ali, A. Ali,2016, Effect of Tade Receivables and Inventory Management on SMEs Performance, British Journal of Economics, Management & Trade, no. 12(4)
- ↑ P. M. Griffin, (2015), How to Read and Interpret Financial Statements: A Guide to Understanding What the Numbers Mean to You, AMA Self-Study
- ↑ E.Piguła, M. Paduszyńska, (2015), Factoring as a Special Means of Financing, Jorunal of Finance and Financial Law, no. II(3)
- A. Harssan Gorondutse, R. Abass Ali, A. Ali,2016, Effect of Tade Receivables and Inventory Management on SMEs Performance, British Journal of Economics, Management & Trade, no. 12(4)
- E.Piguła, M. Paduszyńska, (2015), Factoring as a Special Means of Financing, Jorunal of Finance and Financial Law, no. II(3), p. 104-105
- Gill, J.O. Osgood, W.R. Chatton, M.(2009), Axzo Press, Understanding Financial Statements: Master the Tools That Help You Succeed, Rochester, p. 12
- P. M. Griffin, (2015), How to Read and Interpret Financial Statements: A Guide to Understanding What the Numbers Mean to You, AMA Self-Study, p. 43
- S. Poongavanam,(2017)A Study On Comparative Financial Statement Analysis With Reference To Das Limited, IOSR Journal Of Humanities And Social Science vol. 22, no. 9
- T. Edmonds, (1975)Introduction to Financial Statements for the Practicing Lawyer, National Black Law Journal, vol. 4
Author: Justyna Piekorz