Cash Conversion Ratio

What is the “Cash Conversion Ratio”?

The cash conversion ratio (CCR) compares a company’s operating cash flows with its profitability and is generally calculated using the formula:

The ratio assesses a company’s efficiency in converting its profits into cash; this is important for two reasons. Firstly, in credit analysis, it helps us to understand a company’s cash generation, and secondly, in company valuation, it helps us to assess a company’s earnings quality. The CCR can be expressed as either a multiple or as a percentage.

A higher CCR (typically above 1.0x) is better than a lower CCR as it indicates a business is able to convert a majority of its earnings into cash. Companies may report high earnings, but they need to be converted to cash quickly to meet both short-term and long-term funding needs. A high CCR is often the result of efficient working capital management, such as fast inventory turnover, good receivables management, and favorable credit terms with suppliers.

A low CCR (typically below 1.0x) is concerning for company funding needs but also because it could suggest that a company is concealing poor underlying performance. This is because cash flows are often affected by poor performance before profits. A low CCR could be due to slow inventory turnover from obsolete stock, poor receivables collection because of bad debts, or suppliers tightening their credit terms because they are concerned about the business.

Cash Conversion Ratio Formula

The cash conversion ratio can be calculated using different cash flow and profit measures, but the most common approach is:

Cash Conversion Ratio (CCR) = Operating cash flow / EBITDA

Operating cash flows, also known as cash flow from operations, is a category in the cash flow statement and reflects the amount of cash a company has generated from its core operational activities during a specific period.

EBITDA is the earnings before the effects of interest, taxes, depreciation, and amortization. Although other profit measures, such as EBIT or net income can be used to calculate CCR, EBITDA is the most widely used. This is because it is the closest to a company’s cash flows as it excludes non-cash expenses such as depreciation and amortization.

It must be noted that while EBITDA is pre-interest and taxes, operating cash flows are normally after interest and taxes, so a high level of interest and taxes would lower the ratio.

Example Calculation: Cash Conversion Ratio

Here is a snapshot of the H1 2019 results of DHH International.

DHH S.p.A – Extract from financial highlights for H1 2019

Here is the working of the above in Excel.

This CCR can also be expressed as a multiple (2.5x). This is a very healthy cash conversion ratio. As mentioned in the release, the high CCR is caused by most of the company’s subscriptions being sold as prepaid in advance.

Cash Conversion Ratio and Operating Working Capital

CCR helps measure how well a business is managing its operating working capital. The main difference between operating cash flow and EBITDA is operating working capital. Operating working capital focuses on the operating short-term assets and liabilities required to run a business’ operations. It is calculated as operating current assets (such as receivables and inventory) less operating current liabilities (such as payables).

Positive OWC indicates that operating current assets exceed operating current liabilities, and this working capital requires funding. Negative OWC indicates that operating current assets are lower than operating current liabilities, and this provides the business with access to “free” short-term funding. A growing company with positive operating working capital is more likely to have a cash conversion ratio below 1.0.

Applications of Cash Conversion Ratio

LBO & Credit Analysis

In LBO scenarios and when conducting credit analyses, analysts typically use the following formula to calculate the CCR:

Free Cash Flow (FCF) is the amount of cash freely available to all capital providers. This ratio helps in estimating the debt capacity of a business. Companies with higher cash conversion rates as a percentage of EBITDA will support a much higher debt capacity and vice versa.

Discounted Cash Flow (DCF) Valuation

Discounted cash flow valuation involves forecasting free cash flows to arrive at the value of a business. The DCF involves many assumptions, and analysts construct ratios to check for the reasonableness of these assumptions. Among other things, they check the cash conversion ratio. Ideally, the cash conversion ratio should be higher in the steady-state as a business’ investment requirements reduce during this period.

Download the accompanying Excel files to test your knowledge and for a full explanation of the correct answer.

Additional Resources

EBITDA Margin

Leveraged buyouts (LBO)

DCF Model Training Free Guide