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Improving liquidity and managing working capital

Edexcel IAL Business · WBS12 Managing business activities

When liquidity is weak, a business must release cash or delay payments. The specification names four approaches: assets, supplier credit terms, factoring and just in time inventory.

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Working capital

Working capital = current assets - current liabilities. It is the money available to run the business day to day: paying wages, suppliers and bills.

Too little and the firm cannot pay its debts, may lose supplier credit and could be forced to close even if profitable. Too much ties money up in idle inventory or slow-paying customers.

The working capital cycle: cash buys inventory, inventory is sold (often on credit), customers pay, and cash returns. The longer the cycle, the more working capital is needed.

Four ways to improve liquidity

Assets: sell unused assets, or use sale and leaseback, to raise cash. Risk: assets may be needed later; quick sales may fetch low prices.
Supplier credit terms: negotiate longer credit (for example 60 days instead of 30), so cash stays in the business longer. Risk: suppliers may refuse, charge more or lose goodwill.
Factoring: sell trade receivables (invoices) to a factoring company, which pays a large share (often around 80%) at once and the rest, minus a fee, when the customer pays. Gives immediate cash, but the fee reduces profit and customers may dislike dealing with a factor.
Inventory and JIT: hold less inventory, sell off slow-moving stock, or move to just in time ordering so goods arrive only when needed. Frees cash, but risks running out if suppliers are late.

Other options

Chase debtors and shorten credit given to customers, offer small discounts for prompt payment, arrange an overdraft, or inject new capital. Each improves liquidity in a different way and at a different cost, so the right choice depends on the cause of the problem.

Worked example

A firm factors invoices of $50,000. The factor pays 80% immediately and charges a fee of 4% of the invoice value. How much cash does the firm get now, and in total?

Immediate payment = 80% x 50,000 = $40,000
Fee = 4% x 50,000 = $2,000
Total received = 50,000 - 2,000 = $48,000; the balance of $8,000 comes when the customer pays

Answer: $40,000 now; $48,000 in total

Key idea: Working capital = current assets - current liabilities. Improve liquidity by selling assets, extending supplier credit, factoring receivables or cutting inventory (JIT). Each has a cost or risk.

Check yourself

Current assets are $96,000 and current liabilities are $71,000. Calculate working capital.
Show answer
$25000. 96,000 - 71,000 = $25,000.
A business factors $120,000 of invoices. The factor pays 85% immediately. How much cash is received immediately?
Show answer
$102000. 0.85 x 120,000 = $102,000.
A factor charges a fee of 3% on invoices of $120,000. Calculate the fee.
Show answer
$3600. 0.03 x 120,000 = $3,600, which reduces profit.
Inventory is $45,000 and current liabilities are $60,000; other current assets are $30,000. The firm sells $15,000 of inventory for cash at cost. Calculate the new acid test ratio.
Show answer
0.75. New liquid assets = 30,000 + 15,000 = 45,000; 45,000 / 60,000 = 0.75.
Factoring improves liquidity by
- turning money owed by customers into cash immediately
- giving the business longer to pay its suppliers
- raising the price of the product
- reducing the business's fixed costs
Show answer
turning money owed by customers into cash immediately. The factor pays most of the invoice now.
A risk of asking suppliers for longer credit terms is that
- inventory levels will rise
- the business will lose limited liability
- suppliers may refuse or raise prices
- customers will pay more slowly
Show answer
suppliers may refuse or raise prices. Suppliers bear the cost of waiting.
Moving to just in time inventory improves liquidity but increases the risk of
- running out of materials if a delivery is late
- too much cash being tied up in inventory
- higher storage costs
- goods going out of date in the warehouse
Show answer
running out of materials if a delivery is late. With no buffer, a late delivery stops production.
Explain why working capital is important to a business.
Show answer
Working capital is needed to pay day-to-day costs such as wages and suppliers; without enough, the business cannot pay its debts and may be forced to close even if it is profitable.. It pays day-to-day costs and debts; too little can force closure even when profitable.

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Sources

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.