The Asset Conversion Cycle usually referred to as the Cash Conversion Cycle or Cash Cycle is an important analysis tool that allows the credit analyst to determine more easily why and when the business needs more cash to operate, and when and how it will be able to repay the cash. It is also used to distinguish between the customer’s stated loan purpose and the borrowing cause. Once the cash conversion cycle for the borrower is mapped, the analyst is able to judge whether the purpose, repayment source and structure of the loan are the adequate ones.Managing asset conversion in favor of the business owner is the ultimate goal of transportation logistics and techniques such as just in time inventory.
The Asset Conversion Cycle represents the number of days it takes a company to purchase raw materials, convert them into finished goods, sell the finished product to a customer and receive payment from the customer / account debtor for the product. The ACC has three components (Accounts Receivable Turnover Days, Inventory Turnover Days and Payables Turnover Days). At its simplest expression the asset conversion cycle of a company is defined by the sum of the Accounts Receivable Turnover Days and the Inventory Turnover Days substracting the Accounts Payable Days. First lets look at how these numbers are calculated:
1- Accounts Receivable Turnover in Days. Measures the average number of days from the sale of goods to collection of resulting receivables. It is obtained by the following formula: ( Accounts Receivable / Sales X 365).
For example, A fictional manufacturer of widgets: “Red Widget Co.” with annual sales of $5,000,000 and with accounts receivable outstanding of $500,000 at the end of the year is said to have a 36.5 Account Receivable Turnover in days.
( $500,000 / $5,000,000 ) X 365 = 36.5 days
2- Inventory Turnover. Measures the length of time on average between acquisition and sale of merchandise. For a manufacturer it covers the amount of time between purchase of raw material and sale of the completed product. It is obtained by the following formula: (Inventory / COGS X 365).
Going back to our fictional manufacturer of widgets “Red Widget Co.” let’s suppose that the company had a COGS of $3,000,000 with inventory of $411,000 at the end of the year. It would be said that Red Widget Co. has Inventory turnover days of 50.
( $411,000 / $3,000,000 ) X 365 = 50 days
3- Payables Turnover in Days. Measures the average length of time between purchase of goods and payment for them. It is obtained by the following formula: (Accounts Payable / COGS x 365 ).
This time “Red Widgets Co.” has an accounts payable balance of $456,000 at the end of the year. The result is an accounts payable days of 55.5
( $456,000 / $3,000,000 ) X 365 = 55.5 days
In the case of Red Widget Co. the Cash Conversion Cycle is 31 days. ( 36.5 + 50 – 55.5 ).
Now you may ask yourself why are you doing all that math? Is it just to come up with a number that doesn’t really tells you anything?
To tell you the truth, in real life once you enter the financial information into the software, the computer spits out dozens of ratios most of which are not paid any attention. However, we always look at the cash conversion. We have to because most businesses are not disciplined enough to keep control over the collection of receivables, the managing of inventory or using vendor financing to its fullest. In fact, we will not only look at your ratios, but having access to industry averages, we will compare your company to your competitors and determine how well you are running your company in respect to your peers.
Managing your asset conversion affects your bottom line, your cash flow and influences the amount of external financing needed by your business.