Do you have an outstanding product or service, a committed team, and loyal customers?
Still, does your current situation involve having your working capital locked in inventory, unpaid receivables, and payables that consume your resources?
One key factor in achieving business success is making the most of the resources available and turning them into valuable results.
Two key concepts that play a pivotal role in this endeavor are the asset conversion cycle (ACC) and the cash conversion cycle (CCC).
Keep reading to learn about the ACC and CCC cycles and how they can directly affect your business's financial health, operational efficiency, and overall success.
While they are related, they focus on different aspects of the company's operations.
The asset conversion cycle measures the time it takes for a company to convert its investments in inventory and other assets into cash through sales.
It signifies when a company invests its initial cash in purchasing raw materials to the point of receiving payment from customers for the final products or services provided.
Every business, regardless of its size and nature, possesses an asset conversion cycle comprising two main elements:
The operating cycle encompasses the regular activities of a company, such as producing and selling goods or services, as well as collecting cash from those sales.
On the other hand, the capital investment cycle involves acquiring and utilizing fixed assets necessary for day-to-day operations.
The key components within the asset conversion cycle include:
For instance, you need to pay almost instantly if weekly payments are required.
However, if the supplier allows a monthly payment period, you have a significantly longer timeframe to delay cash disbursement.
During the manufacturing process, it is common for cash to be held for a significant amount of time.
To minimize the amount of time that money is invested in production, you can implement a just-in-time production strategy.
You will receive payments once you issue invoices to your customers.
Therefore, it is crucial to promptly send invoices once you deliver the product or provide the service.
If there are delays in delivering the goods, you can request partial payments from customers in the interim, facilitating a faster cash flow.
The terms you establish when making a sale determine the time required to collect the customer's payment.
If the collection period is lengthy, you may face insufficient cash flow to sustain your business operations.
To calculate the asset conversion cycle, you need to determine the durations of three key components:
1. Days Inventory Outstanding (DIO) measures the average number of days it takes for a company to sell its inventory.
To calculate the average inventory, add the beginning and ending inventory for a specific period and divide by 2.
2. Days Sales Outstanding (DSO) represents the average number of days it takes for a company to collect its accounts receivable.
To calculate the total credit sales, you need to know the sales made on credit during a specific period.
3. Days Payable Outstanding (DPO) measures the average number of days it takes for a company to pay its suppliers.
Like the previous components, you'll need the accounts payable and cost of goods sold values for the same period.
After calculating each of these three components, you can determine the asset conversion cycle using the following formula:
The resulting number will indicate the average number of days it takes a business takes to convert its assets into cash flow.
💡 A shorter ACC indicates that you can convert assets into cash more quickly, which generally signifies better working capital management and liquidity.
The cash conversion cycle is a subset of the asset conversion cycle and focuses specifically on cash flow.
It measures the time it takes for a company to convert its investments in inventory and other resources into cash and then back into cash again through collecting receivables.
The CCC represents the days a company's cash is tied up in the operating cycle.
A shorter CCC indicates the conversion of its investments into cash quickly and efficiently, allowing for better liquidity.
❗In summary, the asset conversion cycle focuses on the overall efficiency of managing inventory, receivables, and payables.
Conversely, the cash conversion cycle explicitly examines the time it takes to convert investments into cash and back into cash through collecting receivables.
To make better financial decisions, you should analyze and compare the asset conversion cycle (ACC) and cash conversion cycle (CCC), along with their components:
The asset turnover ratio measures how efficiently a company converts its investments in assets into sales.
A higher asset turnover ratio indicates that the company is generating more sales per unit of assets.
Since different industries have unique characteristics, comparing this ratio is most significant when conducted within companies operating in the same sector.
The cash conversion rate evaluates how efficiently a company converts its investments in assets into cash. You can calculate it by dividing the net cash from operations by the average total assets.
The cash conversion rate is determined for a specific period, like a quarter or a year.
A higher rate can indicate effective working capital management, which is crucial for maintaining liquidity and meeting financial obligations.
The receivables collection period measures the average number of days it takes for a company to collect payments from its customers.
A shorter collection period indicates better cash flow management and reduces the risk of bad debts.
Monitoring the receivables collection period helps identify any issues with credit policies, customer payment behaviors, or potential liquidity constraints.
The inventory turnover ratio is a financial metric measuring the efficiency of a company's inventory management and sales. It indicates how quickly inventory is sold and replaced over a specific period.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
A higher inventory turnover ratio suggests that a company sells its inventory more quickly, indicating effective inventory management, strong sales, and efficient operations.
On the other hand, a lower ratio may indicate slower inventory turnover, which could be a sign of excess inventory, poor sales performance, or inadequate inventory management.
By comparing these metrics between different periods or benchmarking against industry peers, you can identify areas for improvement.
For ecommerce businesses, inventory is crucial to ensuring customer satisfaction and smooth operation.
But you may face liquidity shortfalls when you experience high demand for top-selling products and need to buy more inventory to meet customer needs.
However, even if a company is performing well, there may come a time when you need additional funds.
In such a situation, what should be the top priority? Here are some options to consider:
1. Focus on replenishing and expanding the inventory to meet customer demand and avoid shortages.
2. Allocate funds towards marketing initiatives to promote the business, attract more customers, and increase sales.
3. Invest in expanding the business by opening a new location to reach a broader customer base and enhance market presence.
4. Hire additional staff members to support business operations, improve productivity, and meet growing demands.
5. Invest in improving the physical infrastructure, such as renovating the store or workspace, to create a better customer experience and enhance the overall business environment.
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The asset and cash conversion cycles are two of the most important factors in maximizing the value of a business.
What's more, you can identify areas where you can improve your performance, such as reducing inventory costs or increasing sales.
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Let's embark on this journey together and set your business up for long-term success!
The operating cycle encompasses the entire process, from raw materials to cash collection, reflecting the company's overall operational efficiency.
The cash conversion cycle evaluates the efficiency of working capital management and the timing of cash inflows and outflows.
No universally ideal CCC exists; it varies across industries and company-specific circumstances. However, companies typically aim to have a shorter CCC relative to their industry peers.