Trade receivables are accounts receivables that arise from commercial transactions.
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 put in the current assets section of a balance sheet if the money is expected to be paid within a year; they represent the accounts receivable for goods and services that have been sold but not paid for.
Trade Receivables Financing
Trade receivables financing, also known as Invoice Finance, is when a company uses 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.
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 factoring firm for £4,850 in return for immediate payment.
While in the above scenario a company might be ‘down’ £150 on the deal, it might be preferable to a situation where the company desperately needs cash to fulfill current orders and meet its liabilities. This might be preferable to a bridging loan from a bank that might involve collateral, thus placing the company’s assets at risk if the loan is defaulted on.
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.
Early Payment Discount Programs
An early payment program is another type of trade finance. It involves the buyer being offered a reduction on the full amount specified in the invoice if the buyer pays earlier than the maturity date set on the invoice.
Early payment programs are also referred to as ‘cash discount’ or ‘early payment discounting’.
There are two methods for early payment discounting. The first is dynamic discounting. This is a system where the buyer gives the supplier the choice of whether to receive early payment on their invoices in return for a reduction in the invoice amount.
With dynamic discounting the supplier has the power to decide which specific invoices it wishes to offer discounts for in return for early payment. The discount rate is calculated using a sliding-scale annual percentage rate (APR). In other words, the size of the discount is determined by how quickly payment is made. Thus, the invoice amount due is smaller for a payment made after 5 days than for a payment made after 14 days.
The second method is when the supplier offers the buyer a discount in exchange for an early payment. This method is particularly suited to smaller suppliers that are often not considered for dynamic discounting programs. As with dynamic discounting the sooner the payment is made, the larger the discount. The terms of the discounting are set out in tiers:
First Tier – If a company pays within 10 days it will receive a 2% discount (and no discount if it pays on day 30)
Second Tier – If a company pays within 20 days it will receive a 1% discount (and no discount if it pays on day 30)
The ‘tier’ approach to discounting gives the buyer the flexibility to choose which discount tier is most advantageous. While delaying payment improves days payable outstanding, this second type of early discounting reduces the cost of materials and services.
The difference between the two approaches essentially boils down to whether it is the buyer or supplier that suggests a reduction in the amount invoiced in return for early payment. However, both methods for early payment provide a flexible financial solution that can be used to manage cash flow and the demands of the supply chain.
Trade receivables are unpaid invoices. Goods or services are provided and an invoice is sent to the buyer. Until the invoice is paid it remains a trade receivable. Trade receivables financing, also known as Invoice Finance, is when a company uses trade receivables to raise money.
Alternatively the buyer or seller can offer an early payment program to facilitate the quicker payment of trade receivables.