managing trade receivables and trade payables

5.1 Business Finance – Working Capital

Think of working capital as the fuel that keeps a business’s cash flow engine running. It’s the money a company uses to pay its suppliers and to collect from its customers.

What is Working Capital?

Working capital is the difference between a company’s current assets and current liabilities:

Working Capital = Current Assets – Current Liabilities

When working capital is positive, the business can cover its short‑term obligations. If it’s negative, the company may struggle to pay suppliers or meet other short‑term debts.

Managing Trade Receivables

Trade receivables are amounts owed by customers. Efficient management reduces the time it takes to collect money.

  1. Set clear credit terms (e.g., 30 days).

  2. Check customers’ creditworthiness before extending credit.

  3. Send timely invoices and follow up on overdue payments.

  4. Offer discounts for early payment (e.g., 2% if paid within 10 days).

📊 Key Metric: Days Sales Outstanding (DSO)

FormulaExplanation
\$DSO = \dfrac{\text{Accounts Receivable}}{\text{Sales}} \times 365\$Average number of days it takes to collect sales.

Managing Trade Payables

Trade payables are amounts owed to suppliers. Managing them wisely can improve cash flow.

  1. Negotiate longer payment terms (e.g., 60 days).

  2. Take advantage of early payment discounts when cash is available.

  3. Keep track of payment schedules to avoid late fees.

  4. Use supplier financing options if available.

📈 Key Metric: Days Payable Outstanding (DPO)

FormulaExplanation
\$DPO = \dfrac{\text{Accounts Payable}}{\text{Cost of Sales}} \times 365\$Average number of days the company takes to pay suppliers.

Balancing Receivables and Payables

Let’s look at a quick example:

  • Accounts Receivable: £50,000

  • Annual Sales: £200,000

  • Accounts Payable: £30,000

  • Annual Cost of Sales: £120,000

Calculate DSO and DPO:

MetricValue
DSO\$ \dfrac{50,000}{200,000} \times 365 \approx 91.25\$ days
DPO\$ \dfrac{30,000}{120,000} \times 365 \approx 91.25\$ days

In this case, the company takes about 91 days to collect sales and also 91 days to pay suppliers, giving a balanced cash cycle.

Exam Tip 🚀

When asked to calculate working capital or cash conversion cycle, always:

  1. Identify the relevant figures (receivables, payables, sales, cost of sales).

  2. Apply the correct formula.

  3. Show all steps and units (days).

  4. Explain the business implication (e.g., a high DSO may indicate collection problems).

Quick Review ??

  • Working capital = Current assets – Current liabilities.

  • DSO measures how long it takes to collect sales.

  • DPO measures how long it takes to pay suppliers.

  • Balancing DSO and DPO helps maintain healthy cash flow.