What it means
Profit and cash are not the same thing. A company can record a large profit while customers owe it money, and it can hold a lot of cash during a poor year if it delays paying suppliers.
Cash conversion measures the gap between the two. The most common measure is the cash conversion ratio, which compares operating cash flow (cash generated by the core business) with a profit figure such as EBITDA (earnings before interest, tax, depreciation and amortisation).
A ratio near 100% means nearly all profit becomes cash. A low ratio suggests that cash is tied up in working capital.
Many things drive the ratio. Growing receivables, rising inventory and shorter supplier payment terms all absorb cash.
Lower receivables, faster stock turnover and longer payment terms release cash back to the business. Do not confuse the ratio with the cash conversion cycle, a related measure.
That cycle counts the days between paying for inventory and collecting cash from customers, so it focuses on time rather than on the share of profit turned into cash. Both are useful, and they often point to the same trouble spots.
Lenders and investors watch cash conversion closely, because cash pays debts and dividends and profit does not. A business with a consistently low ratio may need to borrow to fund growth even when it is profitable.
Management teams use the metric to set targets for credit control and stock levels. Management bonuses and targets sometimes include cash conversion because it rewards the behaviour that creates cash.
Sales teams that offer long payment terms to win deals can lower it, so linking targets to cash as well as revenue encourages healthier contracts. This works best when finance explains the measure clearly.
In practice
Real-world examples
Example 1
A software company reports EBITDA of $4,000,000 and operating cash flow of $4,200,000 because customers pay annual subscriptions upfront. Its cash conversion is 105%. Investors view this as a strong sign. The extra cash helps it fund new products without borrowing from the bank.
Example 2
A building contractor books $1,200,000 of EBITDA, but clients are slow to pay retention money, so operating cash flow is only $600,000. Cash conversion is 50%. The contractor negotiates faster stage payments with new clients. Management also shortens its invoice cycle so that bills go out as soon as each stage is signed off.
Example 3
A fast-growing clothing brand buys a lot of stock ahead of the holiday season. Profit is healthy, yet cash conversion drops to 40% for the year as inventory builds. The finance director arranges a seasonal credit line to cover the gap. Once the season ends and stock sells through, conversion recovers to a more normal level the following year.
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
Worked example: a company reports EBITDA of $2,000,000 and operating cash flow of $1,500,000.
Step 1: Divide operating cash flow by EBITDA: $1,500,000 / $2,000,000 = 0.75.
Step 2: Convert to a percentage: 0.75 x 100 = 75%.
Cash conversion is 75%. The remaining $500,000 of profit was absorbed by working capital, for example higher receivables or inventory.Case study
Seen in the real world
Kestrel Components is an illustrative, fictional electronics maker with EBITDA of $3,000,000 and operating cash flow of $1,200,000. Its cash conversion was only 40%. The owners were puzzled because the business was clearly profitable yet always short of cash.
A review showed that customers took an average of 75 days to pay and that the warehouse held several months of slow-moving stock. The finance team introduced early-payment discounts and cleared old inventory. Within a year, operating cash flow rose to $2,400,000 on EBITDA of $3,000,000, taking conversion to 80%.
The illustrative lesson is that profit alone does not pay the bills. Tracking cash conversion each quarter showed where cash was trapped and gave management a clear target. The board added a cash conversion target to the annual plan, and the sales director agreed to share the cost of late payers with the finance team.
Watch out
Common mistakes
- Assuming a profitable company must have plenty of cash, when profit can be tied up in receivables and stock.
- Judging conversion on one period only, when seasonal swings can distort a single quarter.
- Mixing up the cash conversion ratio and the cash conversion cycle, which measure different things.
Questions
People also ask
What is a good cash conversion ratio?
Many mature businesses aim for something close to or above 80%, but the right level depends on the industry and growth stage. A ratio that stays far below this level for several years deserves investigation.
Can the ratio exceed 100%?
Yes, if working capital shrinks or customers pay in advance, operating cash flow can be higher than EBITDA.
How can a company improve it?
Common steps include collecting faster, reducing stock levels and negotiating longer payment terms with suppliers.
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