managing trade receivables and trade payables

5.1 Business Finance – Working Capital

5.1.1 Why Business Finance Is Needed

• Start‑up finance: purchase of assets, premises set‑up and covering the first months of operating losses.
• Growth finance: funds to increase capacity, enter new markets or launch new products.
• Survival finance: cash to keep the business running during a downturn, seasonal lull or unexpected emergency.
• Cash versus profit: cash is the actual money available to meet short‑term obligations; profit is the residual after all costs have been deducted. A business can be profitable but still run into cash problems if working capital is insufficient.

5.1.2 Short‑Term vs Long‑Term Finance

Aspect	Short‑Term Finance (≤ 12 months)	Long‑Term Finance (> 12 months)
Typical Sources	Bank overdraft, trade credit, commercial paper, factoring, invoice discounting, short‑term loan, merchant’s credit	Share capital, retained earnings, debentures, long‑term loan, leasing, venture capital, retained earnings
Purpose	Financing day‑to‑day operations (inventory, receivables, payables)	Financing capital‑intensive projects (plant, equipment, expansion)
Cost	Usually variable rates; may involve discount fees or early‑payment discounts	Typically fixed interest rates; may include dividend expectations for equity finance
Risk	Refinancing risk if cash flow falls short	Interest‑rate risk and long‑term debt‑service burden

5.1.3 Working Capital

Definition

Working capital is the finance required to fund the day‑to‑day operations of a business.

$$\text{Working Capital}= \text{Current Assets} - \text{Current Liabilities}$$

Why It Matters

• Ensures the business can meet its short‑term obligations.
• Directly influences cash flow, profitability and the ability to seize market opportunities.
• Too little working capital may force expensive borrowing; too much ties up cash that could be invested elsewhere.

Components (Current Assets & Current Liabilities)

Current Assets	Current Liabilities
Cash & cash equivalents, short‑term investments, inventory, trade receivables, pre‑payments	Trade payables, short‑term loans/overdrafts, accrued expenses, tax payable, current portion of long‑term debt

Measuring Business Size (link to 5.1.1)

• Turnover (annual sales)
• Total assets
• Number of employees
• These measures help decide the scale of finance required.

5.1.4 Working‑Capital Cycle & Cash Conversion Cycle (CCC)

The working‑capital cycle tracks cash from the purchase of inventory to the collection of cash from sales.

1. Cash outflow to purchase inventory.
2. Inventory held (Inventory Period).
3. Sale of inventory on credit – creates trade receivables.
4. Cash inflow when receivables are collected (Average Collection Period).
5. Suppliers may grant credit, creating a payable period that offsets part of the cash outflow.

Cash Conversion Cycle (CCC)

$$\text{CCC}= \text{Inventory Period} + \text{Average Collection Period} - \text{Average Payment Period}$$

• Inventory Period = $\dfrac{\text{Average Inventory}}{\text{Cost of Goods Sold per Day}}$
• Average Collection Period = $\dfrac{\text{Trade Receivables}}{\text{Credit Sales per Day}}$
• Average Payment Period = $\dfrac{\text{Trade Payables}}{\text{Credit Purchases per Day}}$

A shorter CCC means cash is tied up for less time, improving liquidity.

Example

• Average inventory = £120 000, COGS = £1 200 000 per year → COGS per day = £1 200 000 ÷ 365 = £3 287.
• Inventory Period = £120 000 ÷ £3 287 ≈ 36.5 days.
• Trade receivables = £90 000, credit sales = £1 800 000 per year → credit sales per day = £4 932.
• Average Collection Period = £90 000 ÷ £4 932 ≈ 18.2 days.
• Trade payables = £70 000, credit purchases = £1 000 000 per year → credit purchases per day = £2 740.
• Average Payment Period = £70 000 ÷ £2 740 ≈ 25.5 days.
• CCC = 36.5 + 18.2 – 25.5 = 29.2 days.

5.1.5 Sources of Finance for Working Capital

5.1.5.1 Short‑Term Sources

Source	Typical Cost	Key Features / Risks
Bank overdraft	Variable (prime + %); arrangement & unused‑limit fees	Reusable up to an agreed limit; requires covenant compliance
Trade credit (supplier credit)	Usually interest‑free; may include early‑payment discount	Depends on supplier relationship; informal documentation
Factoring	Discount 1‑3 % of invoice value + interest on any cash advance	Immediate cash; factor assumes collection risk; reduces profit margin
Invoice discounting	Interest on amount drawn (typically 4‑8 % p.a.)	Business retains control of collections; credit limit linked to receivables
Commercial paper / short‑term loan	Fixed interest, usually lower than overdraft	Requires good credit rating; often unsecured
Merchant’s credit (retail)	Varies; often higher than bank rates	Common in retail; may involve loyalty schemes

5.1.5.2 Long‑Term Sources (used to fund working‑capital requirements when they are large or permanent)

Source	Typical Cost	Key Features / Risks
Share capital (equity)	Dividend expectations; no mandatory repayments	Provides permanent capital; dilutes ownership
Retained earnings	Opportunity cost of not distributing dividends	Internal source; no interest or repayment
Debentures (bond finance)	Fixed interest (coupon) paid annually	Long‑term, usually unsecured; creates fixed interest obligation
Long‑term loan	Fixed or variable interest; scheduled repayments	Requires security; longer repayment horizon
Leasing (finance lease)	Lease rentals (interest component embedded)	Useful for equipment; ownership transferred at end of lease
Venture capital / private equity	High expected return; often equity stake	Provides expertise as well as finance; loss of control possible

5.2 Managing Trade Receivables

5.2.1 Definition & Importance

• Amounts owed by customers for goods sold or services rendered on credit.
• Credit can be a competitive advantage, attracting larger customers and increasing sales.
• Late collection ties up cash, raises financing costs and increases the risk of bad debts.

5.2.2 Factors Influencing Credit Policy

• Industry practice and competitor policies.
• Customer creditworthiness (credit checks, trade references, credit scoring).
• Company’s cash‑flow position and cost of borrowing.
• Risk appetite – balance between sales growth and bad‑debt exposure.
• Legal and regulatory environment (e.g., limits on interest charges).

5.2.3 Common Credit Terms (with examples)

• 2/10, net 30 – 2 % discount if payment is made within 10 days; otherwise full amount due in 30 days.
• Net 45 – No discount; payment due in 45 days.
• Cash on delivery (COD) – No credit; payment required at the point of sale.
• 3 % 30/60 – 3 % discount if paid within 30 days; otherwise payment due in 60 days.

5.2.4 Key Ratios for Receivables

Ratio	Formula	Interpretation
Average Collection Period (ACP)	$$\text{ACP}= \frac{\text{Trade Receivables}}{\text{Credit Sales per Day}}$$	Average number of days to collect cash from credit sales.
Days Sales Outstanding (DSO)	$$\text{DSO}= \frac{\text{Trade Receivables}}{\text{Annual Credit Sales}}\times365$$	Same as ACP but expressed with annual figures.
Receivables Turnover	$$\text{Turnover}= \frac{\text{Annual Credit Sales}}{\text{Average Trade Receivables}}$$	Higher turnover = faster collection.
Bad‑Debt Ratio	$$\text{Bad‑Debt Ratio}= \frac{\text{Bad‑Debt Expense}}{\text{Credit Sales}}\times100$$	Shows the proportion of sales written off as uncollectible.

5.2.5 Managing Receivables

1. Credit Policy – set clear credit limits, require credit checks, and define standard payment terms.
2. Early‑Payment Discounts – e.g., 2 % discount for payment within 10 days. Calculate the effective annualised discount:
   Effective rate = $\left(1+\frac{d}{1-d}\right)^{\frac{365}{n}}-1$ where *d* is the discount (0.02) and *n* is the difference in days (30‑10 = 20). For 2/10, net 30 this gives ≈ 36 % p.a., which helps decide if the discount is worthwhile.
3. Factoring – sell receivables to a factor at a discount (usually 1‑3 % of invoice value). Immediate cash is received, but profit margin falls.
4. Invoice Discounting – borrow against receivables; interest is charged only on the amount drawn. The business retains responsibility for collection.
5. Collection Procedures – automated reminders, dedicated credit control staff, escalation to a collection agency or legal action for chronic defaulters.
6. Provision for Bad Debts – estimate likely uncollectible amounts and record as an expense (allowance method) to avoid overstating profit.

5.2.6 Advantages & Disadvantages of Early‑Payment Discounts

Advantage	Disadvantage
Accelerates cash inflows, reducing the need for external finance.	Reduces revenue if a large proportion of customers take the discount.
Improves customer goodwill and may encourage larger orders.	Administrative cost of monitoring eligibility and processing discounts.
Can be cheaper than borrowing (effective discount rate often exceeds bank rates).	May create a “discount culture” where customers expect ever‑shorter terms.

5.3 Managing Trade Payables

5.3.1 Definition & Importance

• Amounts a business owes to its suppliers for purchases made on credit.
• Supplier credit is a source of short‑term, usually interest‑free, financing.
• Strategic timing of payments can free cash for other uses (e.g., investment or debt repayment).

5.3.2 Factors Influencing Payment Policy

• Supplier relationship and bargaining power.
• Availability of early‑payment discounts.
• Company’s cash‑flow forecast and liquidity position.
• Industry norms – some sectors expect rapid payment, others accept longer terms.
• Credit rating of the business – suppliers may tighten terms if risk rises.

5.3.3 Key Ratios for Payables

Ratio	Formula	Interpretation
Average Payment Period (APP)	$$\text{APP}= \frac{\text{Trade Payables}}{\text{Credit Purchases per Day}}$$	Average number of days the business takes to pay its suppliers.
Days Payable Outstanding (DPO)	$$\text{DPO}= \frac{\text{Trade Payables}}{\text{Annual Credit Purchases}}\times365$$	Higher DPO = longer use of supplier credit (more cash retained).
Payables Turnover	$$\text{Turnover}= \frac{\text{Annual Credit Purchases}}{\text{Average Trade Payables}}$$	Lower turnover indicates cash is being held longer.

5.3.4 Managing Payables

1. Negotiating Terms – seek longer payment periods or early‑payment discounts (e.g., 1 % discount for payment within 15 days).
2. Supplier Relationship Management – maintain open communication, honour agreed dates, and avoid excessive delays that could damage goodwill.
3. Cash‑Flow Forecasting – schedule payments to coincide with expected cash inflows from receivables or other sources.
4. Use of Trade Credit – treat supplier credit as low‑cost financing, but monitor the total amount owed to avoid over‑reliance.
5. Avoid Over‑reliance – excessive postponement may lead to loss of discounts, strained relationships, or tighter future terms.
6. Early‑Payment Discount Decision – compare the effective discount rate (as in 5.2.5) with the company’s cost of borrowing to decide whether to take the discount.

5.3.5 Advantages & Disadvantages of Extending Payables

Advantage	Disadvantage
Improves short‑term cash position without interest cost.	Risk of losing early‑payment discounts and damaging supplier goodwill.
Provides flexibility to match cash outflows with inflows.	Suppliers may impose stricter credit limits or demand cash‑on‑delivery terms.
Can be cheaper than bank borrowing if the effective cost of forgoing a discount is lower than the interest rate.	Potential for supply disruption if a supplier becomes unwilling to extend credit.

5.4 Impact of Credit Policies on Cash Flow, Profitability & Risk

5.4.1 Cash‑Flow Effects

• Generous credit terms increase sales but delay cash inflows, raising the need for working‑capital finance.
• Early‑payment discounts accelerate cash receipts but reduce revenue per sale.
• Factoring provides immediate cash but incurs fees that affect net cash flow.

5.4.2 Profitability Effects

• Bad debts are recorded as an expense, reducing gross profit.
• Discounts and factoring fees lower the gross margin on sales.
• Efficient payables management (taking discounts when the effective discount rate < cost of borrowing) can improve net profit.

5.4.3 Risk Considerations

• High receivable balances increase default risk and may raise the cost of borrowing.
• Over‑extending payables can damage supplier relationships, leading to loss of credit or supply interruptions.
• Reliance on a single large customer or supplier concentrates risk; diversification mitigates it.

5.4.4 Comparative Example – “2/10, net 30” vs “Net 30”

Policy	Cash Inflow (per £1 000 invoice)	Effective Annualised Discount	Impact on Profit
2/10, net 30	£1 020 if paid within 10 days; £1 000 if paid after 30 days	Effective rate = $\left(1+\frac{0.02}{0.98}\right)^{\frac{365}{20}}-1 \approx 36\%$ p.a.	Reduces revenue when discount taken but may be cheaper than borrowing at > 36 %.
Net 30 (no discount)	£1 000 received after 30 days	0 % discount	No revenue reduction; cash is delayed 30 days.

5.5 Summary Checklist for Exam Answers (AS Level)

• Define working capital and give the formula.
• Explain the working‑capital cycle and calculate the Cash Conversion Cycle (CCC).
• Distinguish short‑term from long‑term finance; list at least three sources of each and comment on cost and risk.
• State the purpose of trade receivables and trade payables in working‑capital management.
• Calculate and interpret ACP/DSO, Receivables Turnover, APP/DPO and Payables Turnover.
• Discuss advantages/disadvantages of early‑payment discounts, factoring, invoice discounting and extending payables.
• Analyse how a change in credit policy affects cash flow, profitability and risk.
• Use a brief numerical example to illustrate the effective discount rate and the impact on cash flow.