Master the Asset Conversion Cycle
The Asset Conversion Cycle is made up of two separate and unique cycles that cover the short term, or working assets of the business, and the longer term assets of the business. Let’s examine both cycles more closely.
The first cycle, and most important in my opinion, is the Operating Cycle. We can use the Operating Cycle to break down the various ways a company uses its working assets to ultimately make a sale and collect or convert that sale to cash. It also allows the lender, both from a sales and credit standpoint, to really understand what the business does each day. A business has many business activities, or simultaneous cycles, existing at the same time, and the financials only show the average result of all activities over a specific period of time. This operating cycle brings the financials to life and reveals the connection between the business operations and the resulting financial performance. Using this analysis can help lenders make that important link between the business operations and the numbers.
There are four steps in the Operating Cycle:
- Using assets to purchase goods to sell.
- Produce goods for sale.
- Selling the goods (or service).
- Collect cash from the sale.
Let me give you a simple example of how this works through a pizza takeout restaurant. We start at the top of the operating cycle with cash, which the owners would use to purchase flour to make dough, sauce, cheese, pepperoni, sausage, mushrooms and all the rest of the toppings. When the phone rings or an internet order comes in for a pizza, they would move to the next stage of the operating cycle, which would be to produce or make the order. Once the pizza is cooked, they would move to the next step – selling the pizza, either by delivering it or having the customer pick it up. The final step is collecting the cash from the sale of pizza. This could be in cash, check or credit. If the pizza place received more cash than they paid to make the pizza, they will have a profit.
Clearly, the Operating Cycle is very short for a pizza place. Other types of businesses, no matter the size or complexity, probably will have much longer operating cycles. Understanding these cycles for your borrowers can provide valuable insight into how their business works and what potential lending opportunities it may have. The longer the operating cycle, the higher the borrowing need to finance the cash flow timing differences. Lenders always want to ensure that they provide the appropriate amount of liquidity for their clients.
The second cycle is the Capital Investment Cycle, which is the long-term assets of the business going through a long period of useful life. This is like a building or a piece of equipment. It provides the business long term resources to assist in making money over several years, depending on the useful life of the asset. This cycle is actually made up of many Operating Cycles. So it’s better to understand the underlying operating cycles, even when looking at the capital investment cycle.
Omega Performance’s Financial Accounting for Lenders course can teach your employees more about the asset conversion cycle. Contact us today to learn more!