The Cash Operating Cycle, Working Capital Ratios and Overtrading

Suppose a company buys materials today. It holds them for some weeks, turns them into goods over some more, keeps the goods on the shelf until they sell, and then waits for the customer to pay. Meanwhile its own supplier will be paid, after a credit period.

The number of days between paying the supplier and being paid by the customer is the time for which the company must find the money itself. This is the cash operating cycle, and it is the best single measure of how much working capital a business needs.

This topic explains how to calculate it for a manufacturer, the ratios that make it up, the liquidity ratios and the sales-to-working-capital ratio that judge the position, and overtrading, the dangerous condition of a company that grows faster than its funding. The next topic covers inventory management and the economic order quantity.

These calculations are the core of working capital questions. In November Diet, 2025, Question 2 (20 marks), a distributor’s working capital cycle was calculated as 107 days, recalculated at 41 days on the directors’ targets and the cash released was computed; in May Diet, 2026, Question 1 (30 marks), inventory, receivables and payables days were calculated and appraised for a company showing signs of overtrading. Read working capital: nature, elements and objectives first.

The cash operating cycle

The cash operating cycle, also called the working capital cycle, is the average length of time, usually in days, from the cash outflow to suppliers for goods and services to the cash inflow from customers for sales. It begins when cash is spent on raw materials and ends when cash is received from customers. A shorter cycle means cash is recovered faster and the investment in working capital is lower.

It differs between businesses: a supermarket sells for cash before it pays its suppliers, so its cycle is short, while a manufacturer holds materials, converts them and sells on credit, so its cycle is longer. The cycle has three elements: the credit period taken from suppliers (payables days), the time inventory is held (inventory days) and the credit period given to customers (receivables days).

For other businesses the inventory period is not split. The factors that influence its length are the terms of trade, the efficiency of management, the industry and the company’s policy on the working capital objectives.

The component ratios

• Raw materials holding period = average raw materials ÷ annual raw material purchases × 365.
• Work in progress holding period = average work in progress ÷ annual cost of sales × 365.
• Finished goods holding period = average finished goods ÷ annual cost of sales × 365.
• Average collection period = average trade receivables ÷ annual sales × 365, the credit actually taken by customers.
• Average payment period = average trade payables ÷ annual purchases × 365, which should be near the normal terms in the industry.

Average balances (opening plus closing, divided by two) are preferred, because the year-end figure may not be representative; if only the closing figure is known it is used, with the assumption stated. A low inventory period suggests good control. Where credit sales are only part of sales, use credit sales.

A worked cycle: Lagos Plastics Ltd

Sales are ₦480m, all on credit; cost of sales ₦336m; raw material purchases ₦210m, all on credit. Average balances: raw materials ₦28m, work in progress ₦21m, finished goods ₦42m, receivables ₦63m and payables ₦35m.

If the industry average is 95 days, the company is 9 days longer. Each day of sales is worth ₦480m ÷ 365 = ₦1.32m, so cutting receivables days by 10 would release about ₦13.2m of cash.

Working capital ratios

Liquidity ratios

Liquidity ratios use closing balances. They help to spot cash flow difficulties, and a higher ratio is assumed to be better, although a very high ratio may mean working capital is not used efficiently. The benchmarks are general and should be compared with the industry and with past years.

• Current ratio = current assets ÷ current liabilities. The usual benchmark is about 2:1, meaning current liabilities can be paid twice over.
• Quick ratio (acid test) = (current assets − inventory) ÷ current liabilities. It assumes inventory is not easily turned into cash. The usual benchmark is about 1:1.

Sales revenue to net working capital

Also called the working capital turnover ratio, it is sales revenue ÷ working capital and shows how well the investment in working capital generates sales. A falling ratio may mean working capital is too large for the sales, or inefficiently used.

Lagos Plastics:

• current assets are inventory 91 (28 + 21 + 42), receivables 63 and cash 12, a total of ₦166m
• current liabilities are payables ₦35m and an overdraft of ₦45m, a total of ₦80m.
  The current ratio is 166 ÷ 80 = 2.08
• the quick ratio is (166 − 91) ÷ 80 = 0.94
• working capital is ₦86m and sales ÷ working capital is 480 ÷ 86 = 5.6 times

The current ratio looks healthy but the quick ratio is below 1 because so much is held in inventory.

Overtrading

Overtrading happens when a business tries to do too much, too quickly, with too little long-term capital: it supports too large a volume of trade with the capital resources it has. The characteristics are:

• a rapid increase in revenue;
• an increase in receivables and payables days;
• a significant fall in the liquidity ratios; and
• most of the increase in assets financed by credit (suppliers and an overdraft).

Example: sales rise from ₦300m to ₦420m (+40%) and ₦600m (+43%). Current assets rise from ₦140m to ₦190m and ₦260m, but current liabilities rise from ₦70m to ₦150m and ₦270m. The current ratio falls from 2.0 to 1.27 and then 0.96, working capital falls from ₦70m to ₦40m and then −₦10m, while payables days rise and the overdraft grows. The company is selling more and running out of money.

The remedy is more long-term finance, slower expansion, or tighter control of inventory and receivables.

The opposite condition is over-capitalisation: excessive investment in current assets, shown by rising inventory, a rising receivables period, a high cash balance and fewer payables. The working capital is then larger than needed and profit is lower than it could be.

The ideas in more depth

Why the business cycle is longer than the cash cycle

The business cycle runs from obtaining goods from suppliers to selling them to customers and collecting cash; it is the full period in days (here 165). The supplier’s credit pays for part of it (60.8 days), and the company must fund the rest. Lengthening supplier credit shortens the cash cycle at no cost to the company, but only within the credit the supplier actually allows.

Why the ratios must be read together

A current ratio of 2 with a quick ratio of 0.94 shows that liquidity depends on inventory. A long cash cycle with a fast-growing sales figure suggests overtrading. No ratio is a verdict: each points to a question about policy and trading that management must answer.

Sources and references

• No accounting standard governs these ratios. They are management measures and the definitions vary, so state the formula and the assumptions you use (average or closing balances; credit sales; the 365-day year).

These points are stated as at 5 November 2026.

Worked examples

1. Days.
   63 ÷ 480 × 365 = 47.9 days.

1. Inventory and receivables.
   48.7 + 22.8 + 45.6 + 47.9 = 165.0 days.
2. Cycle.
   165.0 − 60.8 = 104.2 days.

1. Current ratio.
   166 ÷ 80 = 2.08.
2. Quick ratio.
   (166 − 91) ÷ 80 = 0.94.

How to answer in the exam

• Write the formula for each component and state whether you use average or closing balances and credit sales.
• Show every component and the total in a table, with payables deducted.
• Comment against the industry, previous years and the policy changes, and name the likely causes and cures.
• For overtrading, list the signs found in the figures: growth, days, ratios and financing.

Common mistakes in the exam

• Adding payables days instead of deducting them.
• Using sales for inventory days instead of cost of sales (or purchases for raw materials).
• Forgetting that only credit sales belong in receivables days.
• Quoting a ratio without comparing it with a benchmark or trend.
• Confusing overtrading with over-capitalisation.
• Ignoring the assumptions when only year-end balances are given.

Quick revision

• Cycle = inventory days + receivables days − payables days.
• Inventory on cost of sales (raw materials on purchases); receivables on sales; payables on purchases; × 365.
• Current ratio about 2:1; quick ratio about 1:1; sales ÷ working capital shows efficiency.
• Overtrading: fast growth, longer credit days, falling liquidity, asset growth funded by credit.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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