Asset Conversion Cycle Basics

From a financial point of view, the asset conversion cycle, sometimes referred to as the operating cycle of a company, is very important to know and understand by anyone with an interest in a company or industry. If you are a commercial lender and someone comes to you for a loan, it is extremely important that you can identify several things, including what industry type the business is in. When you have established the industry type of a company, you should then be able to map out the asset conversion cycles for the company and compare it to a generalized industry medium and come up with an idea of how well, and in what time frame, it is able to convert assets to inventory, inventory to cash/receivables for debt repayment, and how much cash it has for the next cycle.

Being able to assess a company's asset conversion cycle also will allow you insight into the credit and working capital need, how risky the company is when it generates cash flow to repay its loans, a general idea of what the balance sheet will look like as well as the income statement.

So what exactly is an asset conversion cycle and how do they vary by industry? Well, first we need to define the different types of industries.

The different types of industry are agricultural, manufacturing, wholesalers, retailers, service, and construction. Throughout this range of industry, the asset conversion cycle will change. Certain industries have certain needs for borrowing at different times, and they all vary in when they will generate cash flow to repay their debt.

To truly understand the asset conversion cycle of a company you need to think about how it operates, under what conditions, the risks it faces when producing goods or a service (natural disasters, seasonality, etc) and also figure out the cash flow cycle. For the sake of simplicity we'll save the specifics of each industry for a later date. But we can look at a generalized asset conversion cycle which will give you a good idea of what to look for when trying to evaluate and analyze a company from a financial standpoint.

First we need to ask questions about the company. Things like "What product or service do they offer? Who are the entities customers and who supplies them with goods? How much money do they need to operate their business?" These are all questions that you should ask yourself when assessing a company from a financial point of view.

The most important concept of all is cash flow. How much cash is the business generating when it sells goods or performs a service? Do they generate enough to cover their debt? Do they have excess for new capital? All companies begin their asset conversion cycle with cash; using it to purchase raw materials such as in a construction or agricultural company, or to restock inventory as a retailer.

We use asset conversion cycles as one way of translating how much value a company can add to itself, and it is a one of the critical first steps in financial analysis, whether you are a creditor, commercial or small business lender, a loan officer at a bank, or even an investor. Understanding the asset conversion cycle will give you a good idea of how well a company performs. Analysis of it's risks and debt obligations by looking at the flow of cash to new inventory and labor expenses, how much cash they generate off sales or services, their ability to pay back loans with cash, and what excess cash they have to being the new cycle with will tell you how well they operate in a general period.