3.7.2 - Working capital and efficiency ratios

3.7.2 - Working capital and efficiency ratios

Efficiency ratios reveal how payments, customer credit and inventory affect the use of working capital. This lesson calculates payables days, receivables days and inventory turnover, then explains why comparisons need consistent definitions, business context and evidence beyond the ratio itself.

Payables days and supplier relationships

Payables days estimates how long a business takes to pay its suppliers, linking a balance-sheet amount to costs incurred over a period.

Payables days=Trade payablesAnnual cost of sales×365\text{Payables days}=\frac{\text{Trade payables}}{\text{Annual cost of sales}}\times365

Use cost of sales in the denominator unless a question explicitly supplies a different convention such as annual credit purchases. Payables are amounts owed to trade suppliers; do not use all liabilities or revenue. If the cost figure is for another period, the time multiplier must match it rather than automatically be 365.

A firm has annual revenue £600,000, gross profit £200,000 and trade payables £60,000. The payment period calculated below is an approximation from the accounts, rather than proof of when every invoice was paid.

Worked example 1 - deriving cost of sales

Cost of sales=£600,000−£200,000=£400,000\text{Cost of sales}=£600{,}000-£200{,}000=£400{,}000 Payables days=£60,000£400,000×365=54.75 days\text{Payables days}=\frac{£60{,}000}{£400{,}000}\times365=54.75\text{ days}

Worked example 2 - a furniture maker

Trade payables are £36,000 and annual cost of sales is £438,000.

Payables days=£36,000£438,000×365=30 days\text{Payables days}=\frac{£36{,}000}{£438{,}000}\times365=30\text{ days} Difference from 45-day agreed terms=45−30=15 days\text{Difference from 45-day agreed terms}=45-30=15\text{ days}

The ratio suggests payment earlier than the agreed period on average; invoice records are needed to establish the timing of particular payments.

Tesco's 2025 Annual Report states that its normal supplier-payment terms range from five to 90 days, depending on country, product category and purchase volume. A single benchmark would conceal differences even within one retailer. Compare a ratio with the relevant agreement before describing it as late payment. Tesco, 2025.

A longer payment period can preserve cash in the buyer's business, helping fund inventory and customer credit. However, delaying beyond agreed terms may damage trust, lose early-payment discounts or lead suppliers to withdraw credit, raise prices or prioritise other customers. Paying promptly can support reliable supply but brings cash outflows forward.

Interpret change against the terms. A rise from 30 to 45 days may reflect a negotiated credit agreement or difficulty paying bills. The same ratio can represent efficient financing or financial distress. Consider supplier power, dependence and the value of the relationship rather than assume that maximising payment time is always beneficial.

Receivables days and customer credit

Receivables days estimates how long customers take to pay, so it helps assess the cash tied up in sales already recognised as revenue.

Receivables days=Trade receivablesAnnual revenue×365\text{Receivables days}=\frac{\text{Trade receivables}}{\text{Annual revenue}}\times365

Use annual credit sales instead when the task explicitly supplies that denominator. The first example uses annual revenue £730,000 and receivables £80,000. The result is an approximation, particularly if revenue includes cash sales or the balance is seasonal.

Worked example 1 - converting a proportion into days

Receivables share=£80,000÷£730,000≈0.1096\text{Receivables share}=£80{,}000\div£730{,}000\approx0.1096 Receivables days=0.109589…×365=40 days\text{Receivables days}=0.109589\ldots\times365=40\text{ days}

Retain the unrounded proportion during calculation; it is not itself a number of days.

Worked example 2 - supplied credit sales

A supplier has total annual sales £912,500, credit sales £730,000 and receivables £50,000. Use credit sales as specified.

Receivables days=£50,000£730,000×365=25 days\text{Receivables days}=\frac{£50{,}000}{£730{,}000}\times365=25\text{ days} Using total sales instead=£50,000£912,500×365=20 days\text{Using total sales instead}=\frac{£50{,}000}{£912{,}500}\times365=20\text{ days}

The second result understates the collection period for this task because cash sales do not generate these receivables.

More customer credit can attract buyers who need time to pay, potentially supporting sales and relationships. However, a longer collection period ties up cash, raises financing needs and can increase exposure to bad debts. A profitable sale does not help pay this week's bills if the customer pays much later.

Managers may improve collection through clear terms, prompt accurate invoices, credit checks, reminders or early-payment incentives. They must consider the effect on customers: refusing normal trade credit may push valuable buyers towards competitors. A fall in receivables days may indicate better collection, but could also result from more cash sales or abandoning credit customers. A rise might follow a deliberate growth strategy rather than ineffective administration.

Compare the actual terms, quality of debts and timing with payables and inventory. Collecting from customers after paying suppliers can create a financing gap. That gap matters to cash planning, even when the individual ratios appear reasonable for the sector.

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