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There's a bit more to it than comparing two numbers and deciding "good or bad."
A receivable is an asset and a payable is a liability, so your first intuition might be "assets = good, liabilities = bad." You're not entirely wrong, because the more assets there are in excess of liabilities, the higher the equity value of the company from a book value perspective.
However, a payable is essentially an interest-free loan from a vendor. Even though you typically need to pay your payables within 30-90 days, since you're presumably always buying product from vendors, your payables are a permanent and cheap source of capital for your business. Similarly, the more money my customers owe me that I haven't collected, the more that's a use of capital that, if I could turn it into cash instead, I could deploy elsewhere to achieve a better return.
When companies talk about improving their working capital, this is typically the goal: 1) get their vendors to extend them longer credit terms so the company has more cheap capital (increase payables/liabilities), 2) move inventory out the door and get customers to pay quicker so you're not tying up your capital on your shelves and with your customers (decrease inventory & AR / assets).
Thanks HighlyClevered, i am more concerned in saying if the receivables is 150 and the payables is 147 can we conclude that this is a good thing for the company?
I agree that you generally want to increase payables and reduce receivables to reduce working capital. But what can we say about my receivables 150 given the liabilities can we say the company can afford to pay it's liabilities using these receivables?
What's the actual task here? "Can we say this is a good thing for the company?" depends on who you are. It's not a question that makes much sense in a vacuum.
Equity holders want low net working capital - it boosts returns on equity.
Lenders want high net working capital - it reduces risk that a company will default on its payment obligations.
Does 150 A/R mean they can pay their 147 A/P on time? Not if the A/P is due in 30 days and the A/R is due in 90.
This needs more context.
What conclusion were we going to make if A/R was 50 and A/P was 147? Or is this now a Quick ratio thing?
So in essence you are saying we can be happy that the 150 and 147 are fairly close, but then we need to check the days receivable against the days payable to be able to say the company can pay it's debt sufficiently?
By the way, thanks sir!
Am I right to say this can then be converted to a JOINT ratio that says;
Days Receivable/Days Payable should be close to 1 as long as Receivables/Payables is also close to 1
But then we can't really say this because if Receivables/Payables is also close to 1 then we are not optimising OWC. Interesting?
I think what they're trying to say, and they can can correct me on this, is that at a quick glance, the fact that it’s receivables exceeds its payables is in a very simple way, a good thing.
However, as was mentioned, despite the fact the receivables exceed payables, if the company is required to pay its debts in 30 Days, and it revieves its money from its customers in 90 days, then there is a cash flow problem or an issue with the cash operating cycle, which has been referred to. This is because cash going out of the business is 60 Days prior to cash being revieved by the business, which is obviously a bad thing.
I hope this helps in some way.
It does help, that is why I said a joint ratio.
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