The Asset Conversion Cycle: Asset Conversion Cycle Components

Introduction

Businesses operate in cycles of financing and acquiring assets. There are long-term cycles as non-current assets (long-term
assets) are acquired for start-up and growth, and there are short-term cycles within these as the company funds purchases of
inventory and collects cash from sales. At any point, the company may need to raise new debt or service it for either or both
purposes.

In this lesson, you will learn that current assets typically have a life cycle of one year or less (often referred to as an operating
cycle), whereas non-current assets are used up over a period exceeding one year (the capital investment cycle). You will also
learn that the overall conversion cycle of a company consists of one or more operating and capital investment cycles taking place
simultaneously. The knowledge you gain in this lesson will help you identify the direction of a business’s cash flows and the
opportunities and risks related to financing the business.

By the end of this lesson, you should be able to:

Explain why and how the use of assets is cyclical in nature.

Define the asset conversion cycle.
Explain why efficient management of the asset conversion cycle is critical to a company’s success.
Describe the major components of the asset conversion cycle.
Explain how capital investment cycles are driven primarily by non-current assets.
Explain how current assets of a business drive its operating cycles.

Asset Conversion Cycle and their Components

What You Need to Know

You should be able to explain how assets are consumed through use or realised over time through conversion to products or
collection into cash. You should also know that the life of an asset varies and is cyclical, and that this cyclical nature affects the
business in specific ways. Read the following information to learn more about the components of the asset conversion cycle.
Cyclical Nature of Assets

As an asset is consumed or realised, the business must replace it. For example:
The life of manufacturing equipment is determined by how intensively the company uses
it; as it wears out it will require replacement.
The right of a franchisee to use a franchised name is limited by the term of the franchise
contract; at the end of that term the user must decide whether to replace it.
The life of inventory (or stock) is determined by the speed with which raw materials are
converted into finished products and how quickly the products are then sold. Inventory
must be replaced continuously.
The life of trade receivables depends on the credit terms negotiated with customers; new
receivables arise from new sales.

Asset Conversion Cycle Defined

The asset conversion cycle is the ongoing process through which a company's assets are used up in generating
revenues and cash flow through the business.
Assets are critical to every business, yet the type and structure of assets required to operate a company vary greatly by
industry. The asset conversion cycle thus varies from one sector to another.
At a high level, the asset conversion cycle comprises a continuous set of operating cycles (also called Working Capital
Cycle) within or relating to a series of longer capital investment cycles.

The Asset Conversion Cycle: Cycles within the Cycle

Efficiency in Managing the Cycle

Ultimately, a business profits by selling goods or services at a price that more than compensates the company for its costs
to acquire the necessary assets, finance those acquisitions, and cover business operations involving them. The following
equation generally represents this relationship:

Revenue – Finance Cost – Operating Cost = Profit

Increasing profit is simply a matter of maximising revenues while minimising financing and operating costs.
Efficient management of assets is one way to minimise finance and operating costs.
Financial efficiency is achieved by managing the cycle time of the asset:
Maximising the life of a machine will reduce the frequency of raising new funding for its replacement.
Minimising inventory holding time reduces the cost of funding the gap between payment for inventory and receipt of
cash from sales.
Likewise, a company will want to minimise the time taken from sale to receipt of cash.
 Operational efficiency is achieved by maximising the performance of assets while minimising the cost of obtaining and
maintaining them. For example:
Installing a new quality management system to minimise the number of defective products on an assembly line,
while balancing that with the costs of the system
Balancing the cost of purchasing with the cost of maintaining an asset over its lifetime, while ensuring that operating
quality and capacity are met
Reducing the time that equipment is idle
Minimising the cost of holding inventory while ensuring there is enough to meet demand and avoid inventory
shortages

Components of the Asset Conversion Cycle

The asset conversion cycle consists of a continuous sequence of operating cycles that complement one or more capital
investment cycles.
The capital investment cycle is the time it takes from the acquisition of each non-current asset to its eventual retirement
from use or disposal by way of sale.
The operating cycle (Working Capital Cycle) starts with the purchase of materials and continues through the production
and sale of products or services. The cycle ends when sales are converted through collection from customers into cash.
Cash or credit is required to start the cycle, and cash is the ending point of the cycle.

Show Capital Investment Cycle

Show Operating Cycle

Capital Investment Cycle

Cash or credit is required to start the capital investment cycle. Throughout the cycle, the asset requires further cash or
credit to maintain it and service its financing. At the same time, use of the asset generates cash for the business.
The volume of non-current assets (esp. Fixed Assets) held depends on the industry and the specific business model of the
company. Considerations include the company’s competitive position relative to its rivals and where its products are
positioned in terms of their product life cycles.
Regulatory pressures may also play an important role in the requirement for capital investment and its cycle. Such
pressures might include environmental or health and safety legislation issues and regulation of monopolistic industries
(such as utilities).
Businesses require many different non-current assets, and each has its own cycle time defined by the nature of the asset
and how the business uses it.
Within the cycle, fixed assets must be regularly maintained and sometimes repaired. The extent of such maintenance
affects the asset’s life.
The asset may not on its own generate cash inflows, but may do so in conjunction with other assets and in conjunction
with the business’s operating cycles.
When a fixed asset is retired or disposed of, the business will most likely need to replace or renew that asset to continue to
operate.
Disposal of assets may take place at the natural end of the asset cycle, which occurs when the asset is fully used up, no
longer capable of operating as intended, or obsolete. Alternatively, assets may be disposed of before the end of their
natural cycle as a result of changing business demands or circumstances.
To expand its business, the company must invest in additional assets, which creates further capital investment cycles.

Operating Cycle (WC Cycle)

The operating cycle is dominated by the need for and disposal of current assets.
The main operating assets for most businesses are inventory and trade receivables arising from sales.
Construction and service-based businesses also have work-in-progress assets, which represent the value of work
performed for customers that are yet to be billed.
The operating cycle consists of a sequence of asset conversions. Materials are acquired and, together with labour and use
of non-current assets, are converted into finished products or services. The products or services are then sold and finally
turned into cash (either directly or through trade receivables that are later collected).
Each industry has a typical operating cycle, which businesses aim to manage as efficiently as possible.
 At any time, the quantity and value of current assets can fluctuate significantly, depending on the specific timing of
deliveries, orders, shipments, and receipts.

What You Need to Do

You should understand and be able to explain the relationship involving a company’s business, its asset structure and its asset
conversion cycle. You should also be able to explain the financing and operational requirements and costs surrounding those
assets. The following guidelines will help you do this effectively.

Identify the types of assets held by the business and the mix between non-current and current
assets.
Determine the conversion cycle for each major group of assets.
Understand the competitive position and product life cycle of the business and the impact that
this has on the asset mix and the asset conversion cycles.
Determine the extent to which external forces, such as regulation, drive asset requirements.
Compare the business to its peers over time to see whether it is efficient in managing asset
conversion cycles.
Identify the requirements there would be on assets if the company were to expand or contract.
Review management’s plans for the future and measure the impact those plans may have on
asset conversion cycles.

How This is Useful

It is important that you carefully study the information on assets in the financial statements of a potential borrower. You should
also read trade journals, competitor financial statements, press releases, and other information to learn as much as you can
about the company’s industry and how it works. The following example illustrates how this type of information can be useful.

Asset Conversion Cycle Components: Example

You have recently been appointed as relationship manager to a business that designs and manufactures specialised electronic
components for the aerospace industry. From a quick scan of its financial statements, you see that over recent years the
company has been retrenching. Sales of its less profitable divisions and accompanying assets have reduced its capacity.
However, with recent global developments leading to a surge in airline travel and orders for aircraft, the business expects to
expand again.

You anticipate that as the business tries to take advantage of an upswing in orders, it will need to increase capacity. It will
therefore require financial support for both acquisition of operating assets and investment in new capital assets. You decide to
approach your client to discuss how you might help.

Upon outlining your proposals, you are embarrassed when your client informs you that you had not done your homework about
the business: Much of its working capital requirement relates to specific customer requests, and this design work is typically
financed up front by the customer. Furthermore, you are informed that recent disposals of non-current assets resulted from a
decision to adopt a more flexible manufacturing process, with heavier reliance on outsourcing. This strategy had been outlined in
the management commentary accompanying the previous year’s financial statements, which you had not had time to read. You
resolve to pay closer attention to the asset strategies and financing needs of your borrowers and prospects in the future.

Questions You Should Ask

Asking the right questions can help you understand the asset base and the asset conversion cycle of a business and identify
where its assets are positioned within their conversion cycles. For example, you should ask the following questions:

What are the main features relating to the industry and the business in relation to its asset base and conversion
cycles? Issues to consider include:

Competitive positioning relative to rivals

 Products in terms of their life cycles
Regulatory pressures
Unique operational features such as joint venture operations and outsourcing
Industry-wide developments such as macroeconomic shocks and technological change

What does management say about the business and its strategy that may affect the asset conversion cycle?

What is the average age of non-current assets, and when will they need replacement?

How efficient is the business at managing its non-current assets?

What are typical cycle times within the industry for conversion of inventory into sales and sales into cash? How do
the company’s cycle times compare?

Knowledge Check

Question 1
Which definition correctly describes the asset conversion cycle?

The ongoing process through which a company’s assets are used up in generating revenues and cash flows
through the business

The ongoing process through which materials are acquired, converted into finished products, sold and then turned into
cash

The ongoing process through which financial accounts are recognized when cash changes hands

The ongoing process through which the timing and value of current assets fluctuate depending on the specific timing of
deliveries, orders, shipments, and receipts

The asset conversion cycle is the ongoing process through which a company's assets are used up in generating revenues
and cash flow through the business. At a high level, it comprises a continuous set of operating cycles within or relating to a
series of longer capital investment cycles.

Question 2
Which activity is an example of operational efficiency?

Reducing the amount of inventory held while avoiding shortages.

Building up inventory (stock) to ensure that the business is never caught short on a product.

Purchasing more expensive machinery to reduce maintenance costs.

Extending longer credit terms to customers to attract business.

Operational efficiency is achieved by maximising the performance of assets while minimising the cost of obtaining and
maintaining them. One example of this is reducing the cost of holding inventory while ensuring there is enough to meet
demand and avoid shortages.

Question 3
Which activity is a component of the capital investment cycle?
 The purchase of materials

The production and sale of products or services

Conversion to cash through collection from customers

Maintenance and repair of machinery

The capital investment cycle is the time it takes from the acquisition of each non-current asset to its eventual retirement from
use or disposal through a sale. Maintenance and repair of machinery are part of this cycle.

Question 4
Which statement describes an aspect of the capital investment cycle?

Materials, labour, and the use of non-current assets are converted into finished products and services.

The quantity and value of current assets can fluctuate significantly at any time.

Work-in-progress assets represent the value of work performed for customers that are yet to be billed.

When a fixed asset is retired, the business will most likely need to replace it.

As non-current, fixed assets are used, retired or disposed of, the business will most likely need to replace or renew them. This
is part of the capital investment cycle.

Question 5
Which statement is accurate regarding the operating cycle?

The cycle is dominated by the need for and disposal of non-current assets.

The cycle consists of a sequence of asset conversions, including the acquisition of materials.

The cycle requires that assets be regularly maintained and repaired.

The cycle’s end occurs when the asset is fully used up or no longer capable of operating as intended.

The operating cycle consists of a sequence of asset conversions. Materials are acquired and, together with labour and use of
non-current assets, are converted into finished products or services. The products or services are then sold and finally turned
into cash.

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