What it means
Profit and cash diverge for legitimate reasons: revenue is recognised when earned but received later; costs are accrued before they are paid; depreciation reduces profit but not cash; capital expenditure reduces cash but not profit; inventory built ahead of sales consumes cash without touching the income statement. Over the long run the two converge, since every sale is eventually paid and every asset is eventually consumed, but in any single year they can differ widely, and the pattern of the difference reveals what is happening inside the business.
The cash conversion ratio makes the comparison explicit. The numerator is a cash flow measure: operating cash flow (cash generated from operations after working capital movements and, under some definitions, after tax and interest), or free cash flow (operating cash flow less capital expenditure).
The denominator is a profit measure: EBITDA (the most common, since it is closest to cash before working capital and capex), operating profit, or net income. The choice must be stated, since operating cash flow to EBITDA, free cash flow to net income and the other combinations give different numbers and answer different questions.
A healthy mature business typically converts 80% to 100% of EBITDA into operating cash flow, with the shortfall explained by working capital growth in line with sales, and converts a lower proportion into free cash flow after capital spending. A fast-growing business converts less, because it is investing in receivables, inventory and capacity ahead of the profit they will produce; that is expected, but the investment must be financed and the growth must eventually slow enough for cash to catch up.
A business in decline may convert more than 100% for a while as working capital is released, which can disguise the decline in the cash figures. Low conversion without a growth explanation prompts specific questions.
Are receivables rising faster than sales (customers paying later, or revenue recognised before it is collectable)? Is inventory building (sales slowing, or obsolete stock unrecognised)?
Are costs being capitalised that should be expensed? Is profit being supported by accounting estimates (provision releases, fair value gains) that produce no cash?
Analysts examine the working capital notes and the reconciliation of profit to operating cash flow for the answers, and several accounting scandals were signalled years in advance by earnings that grew while cash flow did not. Managers use cash conversion as a target as well as a diagnostic.
Incentive schemes based on profit alone encourage revenue recognition and cost deferral; adding a cash conversion condition (a bonus paid on EBITDA only if conversion exceeds, say, 85%) aligns the incentive with what the business can actually distribute. Working capital programmes report their results through the ratio, and boards of acquisitive companies watch it for acquired businesses whose profit was flattered before the sale.
In practice
Real-world examples.
Example
A subscription software company converts 110% of EBITDA to cash because customers pay annually in advance.
Example
A construction contractor converts only 40% in a year when it takes on three large projects with milestone payments weighted to completion.
Example
An analyst downgrades a retailer whose profits have risen for three years while operating cash flow has been flat, citing rising inventory and capitalised costs.
Think of it
“Cash conversion measures how well you turn paper profits into real money in the bank.
Formula
Calculation
Cash Conversion Ratio = Operating cash flow / EBITDA x 100%
Free Cash Flow Conversion = Free cash flow / Net income x 100%
Operating cash flow = EBITDA minus Increase in working capital minus Tax paid (definitions vary; state the one used)
Worked example. A distributor reports the following for two years.
Year 1: revenue $50,000,000; EBITDA $6,000,000; depreciation $1,000,000; operating profit $5,000,000; tax paid $1,100,000; increase in receivables $400,000; increase in inventory $300,000; increase in payables $250,000; capital expenditure $900,000; net income $3,400,000.
- Working capital increase = $400,000 + $300,000 minus $250,000 = $450,000
- Operating cash flow = $6,000,000 minus $450,000 minus $1,100,000 = $4,450,000
- Cash conversion (OCF / EBITDA) = 74%
- Free cash flow = $4,450,000 minus $900,000 = $3,550,000; FCF / net income = 104%
Year 2: revenue $56,000,000 (up 12%); EBITDA $7,200,000; depreciation $1,100,000; tax paid $1,300,000; increase in receivables $2,100,000; increase in inventory $1,500,000; increase in payables $300,000; capital expenditure $1,000,000; net income $4,200,000.
- Working capital increase = $2,100,000 + $1,500,000 minus $300,000 = $3,300,000
- Operating cash flow = $7,200,000 minus $3,300,000 minus $1,300,000 = $2,600,000
- Cash conversion = 36%
- Free cash flow = $1,600,000; FCF / net income = 38%
Profit grew 24% and cash conversion halved. Sales grew 12%, so receivables and inventory should have grown by roughly 12% too: on year-1 balances of, say, $8,000,000 and $6,000,000, that would be about $960,000 and $720,000, not $2,100,000 and $1,500,000. Receivables have grown more than twice as fast as sales (DSO has moved from about 58 to 66 days) and inventory similarly. The board asks whether year-end sales were pulled forward with extended terms, whether a large customer is paying late, and whether the inventory build reflects slowing demand. The answer turns out to be a mix: a new major customer on 90-day terms, and $800,000 of stock bought ahead of a price increase. Both are defensible, but the finance director's report sets a cash conversion target of 75% for year 3 and adds it as a condition to the management bonus.Case study
Seen in the real world.
A listed industrial group had reported steadily rising profits for four years and paid rising dividends. Its operating cash flow had barely moved. Each year the annual report explained the gap by working capital investment "to support growth", and each year the explanation was accepted.
A fund manager's analyst built a five-year table of EBITDA, operating cash flow and the conversion ratio, which had fallen from 92% to 48%, alongside receivable days (up from 55 to 88) and inventory days (up from 70 to 115). She also noticed that capitalised development costs had grown from $5 million to $28 million. The fund sold its holding.
Eight months later the group announced that a review had found revenue recognised on contracts before the customers had accepted delivery, inventory that should have been written down, and development costs that did not meet the criteria for capitalisation; profits for three years were restated downward by 40%, the dividend was suspended and the share price fell by two thirds. The cash flow statement had been telling the truth throughout: the cash had never arrived because the profits had never been real. The fund's analyst later described cash conversion as the ratio that cannot be talked away, since a business can explain a low figure for a year, but not a falling one for five.
Watch out
Common mistakes.
- Assessing performance on profit alone. Profit that does not convert into cash cannot be distributed or reinvested, and a widening gap is a warning.
- Comparing cash conversion ratios calculated on different definitions (OCF to EBITDA, FCF to net income, before or after tax) without adjusting.
- Accepting "working capital to support growth" as an explanation without checking that working capital has grown in proportion to sales rather than faster.
Questions
People also ask.
What is a good cash conversion ratio?
For a mature business, operating cash flow of 80% to 100% of EBITDA. Growing businesses convert less; the question is whether the investment is proportionate and financed.
Can cash conversion exceed 100%?
Yes, when customers pay in advance, payables are stretched, or working capital is released as the business shrinks. Sustained conversion far above 100% deserves as much scrutiny as conversion far below.
Why use EBITDA rather than net income as the denominator?
EBITDA excludes depreciation, interest and tax, so it is the profit measure closest to operating cash flow before working capital; the ratio then isolates the working capital effect. FCF to net income captures the whole picture including capex, interest and tax.
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