Have you ever had the feeling that running your business was one big juggling act? Surely, successful business owners don’t have to keep so many balls in the air. It may be hard to believe, but this is a very fitting image for a successful business.
Financially, every business operates in terms of managing assets, liabilities, and equity to generate a return. It may come as a surprise that all large companies run the same way. The corner market, accountant, e-commerce store, even the plumber are all organized around three cycles, many without even realizing it. Let’s dive in to more fully understand these three cycles and how they can benefit your business.
The Operating CycleA business’s operating cycle encompasses the day-to-day activities, including the things you make, buy and sell. The financial statement illustrates the operating cycle in a couple of places.
The balance sheet places it first, as current assets and liabilities (also called short-term assets and liabilities). The statement of cash flows also places the operating cycle at the top. The income statement focuses primarily on revenues and expenses from the operating cycle.
In case you’re wondering, current assets and liabilities are things you hold for a year or less. That’s the entire length of the operating cycle. Most businesses organize their finances around a year’s team, so this makes perfect sense. It’s often not until the end of the year that you know if you’ve made a profit and, if so, how much you made.
Within a year, other elements of your business are running on even shorter cycles. You make tax payments quarterly, pay rent monthly, and make payroll every two weeks. Inventory turnover and receivables especially have their own cycles. These revolve several times over the course of the year.
The operating cycle is the easiest level to picture because it reflects what you do in your business every day.
The Assets CycleThe largest part of your balance sheet is dedicated to long-term assets and liabilities. The assets include the property, vehicles, and equipment you own. On the other side of the balance sheet, you’ll find the debt you took on in order to acquire these assets. Unlike the operating cycle, these assets have a lifespan of many years. Depending on the asset, the lifespan could be two years, 15 years, 30 years and sometimes more.
Acquiring, managing, maintaining, and ultimately selling these assets will consume a large amount of your time as the business manager. As you start working with these assets, you come to understand that they each have their own cycle. The Statement of Cash Flows in your financial statements calls this “Investing Activities.” I think calling it the asset cycle better captures what it’s all about.
In the operating cycle, you carry out activities that generate your sales and profits. In the asset cycle, you are building up your company’s capacity to carry out those operations. If you are a manufacturer, it’s all the equipment you use, but not the raw materials or the finished products. You buy more or newer equipment to produce more products to sell.
If you’re in the rental property business, you acquire more properties so you can lease them out. Again, this is what runs and grows your cash flow. When you manage the assets cycle properly, you are strategically thinking about how you can improve and grow your business. You will think strategically when it’s time to reinvest in those assets or sell them and perhaps acquire a new asset.
The interplay between the assets cycle and operating cycle is at the heart of your business. However, the third and final cycle is just as important.
The Entity CycleThis cycle often gets overlooked by many small business owners because it doesn’t impact their day-to-day operations, but it’s critical that you understand what’s going on in this third cycle. By understanding the entity cycle, you’ll be able to make the best decisions about the overall health and direction of your business.
If you look at your financial statements at the statement of cash flows, you’ll see three cash flow levels from operations, investing, and financing. Using the terms “investing” and “financing” here can get a little tricky, because these words are used to describe so many different things. Instead, I refer to them as the asset cycle and the entity cycle.
The entity cycle covers the lifespan of your business as an entity. It covers the company’s formation, how it grows through time, and how the company ends. If you are successful, you will hopefully see a positive return at the end of the cycle. For instance, when selling your company to another purchaser, including a family member, you want to see your company grow.
When you put equity into the business, you are working in the entity cycle. The equity that stays and grows within your company is moving in this entity cycle. When you take out equity (this could be at exit or before) you are moving in this entity cycle.
The entity cycle is the longest of the three. A well-run business will outlive its long-term assets, like vehicles or equipment, cycling through these multiple times.
This is not just a concept that only applies to big businesses. It’s important to recognize that every business–including your business–also works this way. If you bring in other investors, they will think about their investment along this cycle, and you should too.
In summary, once you understand the differences between these three cycles and how they work together, you will be in a much better position to make the right decisions for your business and get back more from all that you have put into it.