The asset conversion cycle
/What is the Asset Conversion Cycle?
The asset conversion cycle is the process by which cash is used to create goods and services, deliver them to customers, and then collect the resulting receivables and convert them back into cash. The nature of this cycle determines the extent to which a business has either a net cash inflow or outflow. The key factors in the cycle are noted below.
Materials Acquisition
Under what terms does the company pay its suppliers? If the payment terms are extremely short, the business will be required to come up with the cash to pay for its materials almost at once. The same concept applies when a business provides services – a weekly pay period requires the almost immediate disbursement of cash, while a monthly pay period allows a firm to hold off on cash disbursements for a substantially longer period.
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Production Duration
The production process can tie up cash for quite a long period of time. An operation that uses short machine setup times, keeps fewer jobs on the production floor at one time, and employs a just-in-time production philosophy can drastically cut the time period during which cash is tied up in production.
Billing Speed
A business cannot be paid if it does not bill the customer. Consequently, billings should be issued as soon as delivery has been completed. In situations where delivery will not be complete for some time, there should be partial payment requirements in the interim that accelerate the flow of cash.
Collections
The time required to collect cash from customers is controlled by the terms given to them at the beginning of a sale. A lengthy collection period can drastically impact the amount of cash needed to operate a business.
The preceding factors can be adjusted to extend payment terms to suppliers, shorten the production process, and accelerate billings to and collections from customers. The outcome should be a significant reduction in the cash required to maintain the entire asset conversion cycle. These changes could result in a switch from a net cash outflow to a net cash inflow.
How to Calculate the Asset Conversion Cycle
The asset conversion cycle can be calculated by combining its three main elements, which are days sales outstanding, days inventory outstanding, and days payable outstanding. Days sales outstanding is the average number of days required to collect cash from customers, following the billing date. Days inventory outstanding is the average number of days required to sell inventory. Days payable outstanding is the average number of days required to pay suppliers. The formula for the asset conversion cycle is as follows:
Days sales outstanding + Days inventory outstanding - Days payable outstanding = Asset conversion cycle