The two main categories on a company balance sheet are assets and liabilities. Trade receivables are put in the asset section of a balance sheet; they represent invoices for goods and services that have been sold but not paid for.
Trade receivables are classified as current assets if the money is expected to be paid within a year. After a year of non-payment, the unpaid bills move off the asset section of a company balance sheet.
A distinction needs to be made between trade and non-trade receivables. Whereas trade receivables are promises of payment for goods and services delivered, non-trade receivables are promises of money that arise from things other than trade. These could include tax refunds or insurance claim pay-outs.
Trade receivables are also referred to as accounts receivable. They stand in contrast to accounts payable, which refer to money owed by the company. Accounts payable would include such things as energy bills and taxes due.
Double Entry Accounting
For those not versed in accounting, the idea of a balance sheet made of two columns – money coming in and money going out – is easy enough to understand. However, in practice accounting is more complicated. Business accounting uses the double entry accounting system.
Under the double entry accounting system if a sale is made and an invoice is raised but not paid for yet the sale is credited in the sales account. At the same time the invoice amount is put in the debit column in the trade receivables account. Thus, one entry has the invoice as an asset and another as a pay-out. That is why it is referred to as ‘double entry accounting’.
Once the invoice has been paid the entries are modified: the sales account is debited the amount in question, and the trade receivables is credited the amount in question.
A significant indicator of the financial health of a company is working capital. This is calculated by ascertaining current assets and then subtracting current liabilities. Trade receivables fall into the category of current assets which also include such items as inventory and cash.
Calculating working capital is important for business, as it gives a good indication of the financial health of a company. The less money that is available to a company, the more it is constrained in its activities.
Days Sales Outstanding and Days Payable Outstanding
Business analysts dig deeper into working capital by calculating days sales outstanding (DSO) and days payable outstanding (DPO). These indicate how quickly a company is being paid for its goods or services.
Days sales outstanding refers to the time taken for an invoice to be paid by a customer. The smaller the number for DSO the better it is for a company. It means they are being paid swiftly and have cash on hand.
Days payable outstanding refers to the buyer. It is the number of days available to pay an invoice for goods or services received. It is in the buyer’s interest to increase the DPO.
Put simply the seller wants to be paid quickly and the buyer wants to delay payment for as long as possible. This is an inherent problem in business.
Solving the Problem
Having to wait for payment for goods and services ties up money that could be spent on recurring expenses such as wage bills and costs for materials. It could be invested in machinery or research and development (R&D). It can be hard to keep on filling orders when the payments are delayed, stretching cash flow.
One solution is to finance trade receivables. This means to sell unpaid invoices for goods and services for a discount in return for early payment. So, if a company has an outstanding invoice worth £5,000 that is not due to be paid for 90 days it might make good financial sense to sell the invoice to a third party for £4,500 in return for immediate payment.
While in the above scenario a company might be ‘down’ £500 on the deal, it might be preferable to a situation where the company desperately needs cash to fulfil current orders and meet its liabilities. Bridging loans from banks might involve collateral, thus placing the company’s assets at risk if the loan is defaulted on.
Accounts Receivable Financing and Receivables Finance
The difference between accounts receivable financing (AR) and receivables finance will be scrutinised in a separate post. They both involve using trade receivables to raise money. Essentially, a company has unpaid invoices that they can use to raise cash. One common way to do this is to approach a factoring firm that will buy the outstanding invoices for a discount in return for an instant cash payment normally between 75% and 90% of the face value of the invoice, minus costs.
There are a number of ways that a factoring contract can be structured. As mentioned, this is a topic for a dedicated post.
One common alternative to accounts receivable financing is to approach a lender for asset-based lending (ABL) facilities. In this case, cash is loaned to a company against collateral. This collateral can be trade receivables or other assets such as equipment or commercial property.
Early Payment Programs
These are programs initiated by the buyer rather than the seller. These provide another route to securing early payment for goods and services. The advantage of early payment programs is that the costs can be less than using a factoring company.
Two examples of early payment programs are supply chain financing and dynamic discounting.
T.S Eliot famously wrote, ‘Between the motion and the act falls the shadow’. He could have been talking about business accounting: between fulfilling an order and being paid falls a shadow of uncertainty. Companies have to wait for payment (often between 30 and 90 days), and that is a time when the buyer or seller could go insolvent. World events could intervene to jeopardise a deal. Recently, Covid-19 and the war in Ukraine are just two examples of how world events can lurk in the shadows only to appear and bankrupt a company.
One way to plan against these and other possible serious setbacks is to use trade receivables to generate early payment and avoid the ‘shadow’.