Understanding Asset Conversion Cycle

Understanding Asset Conversion Cycle

An asset conversion cycle refers to the process of a company using its cash in manufacturing products or providing services, give them to its clients, collect the receivables (Also see What Are Accounts Receivables and Bad Debts?) before turning them into cash again. This cycle helps the business owners to determine whether their companies have a net cash inflow or outflow.

Cash flow is crucial for all type of business as it enables the company to continue its operation smoothly (Also see Avoid These Mistakes When Forecasting Cash Flow). Apart from knowing the asset conversion cycle, you, as a business owner, should also make sure that your company has kept all the accounting records and done the related tasks properly to ensure healthy cash flow. If accounting is not your thing, and your small company cannot afford to hire an in-house accountant, then you should consider engaging an accounting firm in Johor Bahru to help you out.

The essential elements in the asset conversion cycle are:

Material acquisition

If a company has extremely short payment terms with its supplier, it has to have the full amount of cash it requires to purchase the goods or services as it needs to make the payment almost at once. If the company needs to make the payments weekly, it means that it needs to pay for what it has acquired almost immediately. However, if its supplier offers a monthly pay period, the company will have a considerably more extended period for it to postpone the cash disbursement (Also see Procedures in a Supplier Audit).

Duration of production

The cash a company owns may be tied up for quite a long time in the manufacturing process. If a company wants to shorten the time in which its cash is tied up in production significantly, it may implement a just-in-time production system, as well as reduce the number of jobs the workers are doing in the shop floor at a time.

Speed of billing

As long as the business does not bill its clients, it will not receive the payment. Thus, companies should issue billings to their clients once they have delivered the product or provided the services. If they are unable to deliver the goods for some time, they should request their clients to make partial payments in the intervening time. This helps in accelerating its cash flow.

Collection period

The terms a company has given to its clients initially when they have made the sale will determine the time it requires to collect the payment from its clients. If the collection period is long, the company may not have enough cash to maintain its operations (Also see Understanding Cash Conversion Cycle (CCC)).

Business owners may make some adjustments to the elements above, for example, request their suppliers to lengthen the pay period, shorten the duration of production, increase the speed of billing and collecting receivables. If they do so, they will find out that the cash their companies need to maintain the whole asset conversion cycle has reduced significantly. This may even cause a change in cash flow, where a net cash outflow can switch to net cash inflow in some cases.