The ratio of the cash flow of a company to its net profit
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What is the Cash Conversion Ratio (CCR)?
The Cash Conversion Ratio (CCR), also known as cash conversion rate, is a financial management tool used to determine the ratio of a company’s cash flowsto its net profit. In other words, it is a comparison of how much cash flow a company generates compared to its accounting profit.
Understanding Cash Conversion Ratio Calculations
When calculating CCR, cash flow is the center of the equation. It is used to determine all cash generated in a given financial period – often quarterly or annually, depending on the company’s accounting cycles.
Cash Flow is generally broken down into three categories:
- Operating activities – Cash generated from the operation of the business
- Investing activities – Covers all purchases and sales of long-term investments and assets
- Financial activities – Covers all transactions related to raising (or repaying) capital
In this case, we want Cash Flow from Operations, orFree Cash Flow(which is equal to operating cash flow minus capital expenditures).
Once cash flow is determined, the next step is dividing it by the net profit. That is the profit after interest, tax, and amortization. Below is the cash conversion ratio formula.
The resulting ratio from this calculation can be either a positive value or a negative value. It can be summarized as: if the ratio is anything above 1, it means that the company possesses excellent liquidity, while anything below 1 implies a weak CCR. Anything negative suggests the company is incurring losses.
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Takeaways
Below are some of the takeaways from calculating the Cash Conversion Ratio of a given company.
1. CCR is a quick way to determine the disparity between a company’s cash flow and net profit
A high cash conversion ratio indicates that the company has excess cash flow compared to its net profit. For mature companies, it is common to see a high CCR because they tend to earn considerably high profits and have accumulated large amounts of cash.
In contrast, companies in the start-up or growth stage tend to have low or even negative cash flows due to the required amount of capital invested in the business. In early stages, companies often find themselves earning negative profits until they reach a break-even point, thus the CRR of these companies would also be negative or low.
2. It is a tool for management decisions
While a high CRR could be a good sign for liquidity, having too much excess cash might imply that the company is not utilizing its resources in the most effective way. The company should consider re-investing in profitable projects or expanding its operations to further enhance the profitability of the business.
When the ratio is low or negative, it could be an indication that the company needs to adjust its operations and start figuring out which activities are sinking its income or whether it needs to expand its market share or increase sales in favor of revamping cash flows.
3. It is an investing indicator tool
To investors, what matters is whether a given company is generating enough cash flow to provide a solid return per share. Thus, significant investment opportunities will offer a higher ratio, while a weak investment will show a lower ratio.
However, some companies may dubiously try to alter the ratio, especially the cash flow part, to attract investors. That’s why proper scrutiny of the books of accounts should be conducted first before making an investment decision based on CCR.
Terms Related to Cash Conversion Ratio
There are familiar terms that look similar to the cash conversion ratio, but they carry a different meaning. They include:
Cash conversion cycles (CCC)
CCC is used for measuring management effectiveness by determining how fast a company can convert cash inputs into cash flows over a given production and sales period.
Conversion cycle
In portfolio management, it is used to determine the number of the common shares which a company has been receiving at a specific time of conversion of each convertible security. That is the ratio of per value of convertible bond divided by the conversion price of equity.
Other resources
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FAQs
What Is the Cash Conversion Ratio? The cash conversion ratio is a metric that determines the proportion of a business's earnings before interest, taxes, depreciation, and Amortization that is converted into operating cash flow for meeting various financial obligations, such as paying off debts or funding investments.
How do you calculate cash conversion? ›
The formula for calculating the cash conversion cycle sums up the days inventory outstanding and days sales outstanding, and then subtracts the days payable outstanding.
What is a good FCF conversion ratio? ›
A “good” free cash flow conversion rate would typically be consistently around or above 100%, as it indicates efficient working capital management. If the FCF conversion rate of a company is in excess of 100%, that implies operational efficiency.
What is the cash convergence ratio? ›
The Cash Conversion Ratio (CCR), also known as cash conversion rate, is a financial management tool used to determine the ratio of a company's cash flows to its net profit. In other words, it is a comparison of how much cash flow a company generates compared to its accounting profit.
What does cash conversion cycle ratio indicate? ›
Essentially, CCC represents how fast a company can convert the invested cash from start (investment) to end (returns). The lower the CCC, the better. Inventory management, sales realization, and payables are the three key ingredients of business.
What is a good cash conversion ratio? ›
What Is Considered a "Good" Cash Conversion Ratio? Depending on the particular industry your enterprise is in, a good CCR will differ. In general, however, a CCR of 1 indicates that a business efficiently converts every dollar of net income to cash.
How to find conversion ratio? ›
The conversion ratio can also be found by taking the bond's par value, which is generally $1,000, and dividing it by the share price. A stock trading for $40 has a conversion ratio equal to $1,000 divided by $40, or 25.
What is a good conversion ratio? ›
In fact, a “good” website conversion rate falls between 2% and 5% across all industries. Industry-specific conversion rates vary quite a bit more. Some industries, like industrial equipment, have very low-performing websites.
What is Tesla's FCF ratio? ›
Hence, Tesla's Price-to-Free-Cash-Flow Ratio for today is 454.92. During the past 13 years, Tesla's highest Price-to-Free-Cash-Flow Ratio was 544.60. The lowest was 27.53. And the median was 154.80.
How do you calculate cash flow conversion ratio? ›
Certain practitioners calculate the cash conversion ratio by dividing free cash flow (FCF) by cash from operations (CFO). Where: Free Cash Flow (FCF) = Cash Flow from Operations (CFO) – Capex. EBITDA = Operating Income (EBIT) + Depreciation and Amortization (D&A)
In general, a cash ratio equal to or greater than 1 indicates a company has enough cash and cash equivalents to entirely pay off all short-term debts. A ratio above 1 is generally favored, while a ratio under 0.5 is considered risky as the entity has twice as much short-term debt compared to cash.
Is a cash ratio of 0.2 good? ›
A cash ratio of 0.2 suggests that a company has 20% of its current liabilities covered by cash and cash equivalents. While this may not be considered high, the adequacy of the ratio depends on various factors such as industry norms, business model, and specific circ*mstances of the company.
What is an acceptable cash ratio? ›
There is no ideal figure, but a cash ratio is considered good if it is between 0.5 and 1. For example, a company with $200,000 in cash and cash equivalents, and $150,000 in liabilities, will have a 1.33 cash ratio.
What is a bad cash conversion cycle? ›
What Does a Negative CCC Mean? A negative cash conversion cycle means that inventory is sold before you have to pay for it. Or, in other words, your vendors are financing your business operations. A negative cash conversion cycle is a desirable situation for many businesses.
Do you want a high or low cash conversion cycle? ›
The cash conversion cycle matters to you, as well. A low CCC indicates you are doing well at converting inventory to cash and shows your business is operating efficiently. On the other hand, if your CCC is too high, it may be a sign of operational issues, a lack of demand for your product, or a declining market niche.
What is the ideal cash conversion cycle? ›
Generally, a shorter cash conversion cycle indicates optimised and efficient working capital management. Ideally, a cash cycle averages between 30 to 45 days. However, these cycles can vary significantly between industries.
What is the formula for cash conversion cost? ›
Cash Conversion Ratio Formula
Net Income = Pre-Tax Income (EBT) – Income Taxes. Cash Flow from Operations (CFO) = Net Income + Depreciation and Amortization (D&A) – Increase in Net Working Capital (NWC) (+/–) Non-Recurring Items.
How do you calculate cash conversion score? ›
It is impossible to have a high CCS without strong product/market fit and a scalable sales and marketing model. Cash Conversion Score is calculated by dividing the current ARR by the difference between Total Capital Raised to Date and Cash on Hand, where Total Capital Raised to Date = Equity + Debt.
What is the formula for calculating conversion rate? ›
Conversion rates are calculated by simply taking the number of conversions and dividing that by the number of total ad interactions that can be tracked to a conversion during the same time period. For example, if you had 50 conversions from 1,000 interactions, your conversion rate would be 5%, since 50 ÷ 1,000 = 5%.
What is the formula for average cash conversion? ›
Cash Conversion Cycle = DIO + DSO – DPO
DIO stands for Days Inventory Outstanding. DSO stands for Days Sales Outstanding. DPO stands for Days Payable Outstanding.
