What Is Cash Flow Conversion? (2024)

FAQs

What Is Cash Flow Conversion? ›

The cash flow conversion ratio is a one-step calculation measuring your business's efficiency in turning sales into cash. It's a liquidity ratio comparing operating profits and free cash flow over the period in question.

Free Cash Flow Conversion is a liquidity ratio that measures a company's ability to convert its operating profits into free cash flow (FCF) in a given period. By comparing a company's available free cash flow to an operating metric, the FCF conversion rate helps evaluate the quality of a company's cash flow generation.

Key Takeaways

The cash conversion cycle (CCC) is a metric that expresses the number of days it takes for a company to convert its inventory into cash flows from sales. The shorter the cash conversion cycle, the less time cash is in accounts receivable or inventory.

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)

When it comes to cash-flow management, one general rule of thumb suggests enough to cover three to six months' worth of operating expenses. However, true cash management success could require understanding when it might be beneficial to invest some cash elsewhere as well.

Example of the Cash Conversion Cycle

DIO = ($1,500 / $3,000) x 365 days = 182.5 days. DSO = ($95 / $9,000) x 365 days = 3.9 days. DPO = $850 / ($3,000 / 365 days) = 103.4 days. CCC = 182.5 + 3.9 - 103.4 = 83 days.

The cash cycle, or cash conversion cycle, is the time it takes for a company to convert its investments in inventory into cash flow from sales. It's measured by adding days inventory outstanding to days sales outstanding and subtracting days payable outstanding.

But you should also consider evaluating “good” free cash flow in terms of Bessemer's efficiency score — the sum of your growth percentage and free cash flow margin percentage. Like the rule of 40, anything above 40 in this calculation is considered “good” and bodes well for the valuation of your SaaS company.

In general, however, a CCR of 1 indicates that a business efficiently converts every dollar of net income to cash. A CCR above 1 means that you have high liquidity that you can then use to invest in business growth strategies like marketing, product development, or hiring.

The shorter a company's CCC, the less time it has money tied up in accounts receivable and inventory. The cash cycle is an important working capital metric for all companies that buy and manage inventory. It's an indicator of operational efficiency, liquidity risk, and overall financial health.

Is a negative cash conversion cycle good or bad? ›

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.

To convert your accrual net profit to cash, you must subtract an increase in accounts receivable. The increase represents income that has been recorded but not yet collected in cash. A decrease in accounts receivable has the opposite effect — the decrease represents cash collected, but not included in income.

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.

Cash flow refers to money that goes in and out. Companies with a positive cash flow have more money coming in, while a negative cash flow indicates higher spending. Net cash flow equals the total cash inflows minus the total cash outflows.

Many real estate investors are happy with cash flow of $100-$200 per month per unit, but this should be viewed within the wider context of your portfolio and financial goals.

Following the 10% rule is another way to calculate the rate of average cash flow. Divide the yearly net cash flow by the amount of money that was invested in the property. If the result is over 10%. Then this is a sign of positive and a good amount of average cash flow".

Free cash flow conversion (FCF) is a formula used to measure your ability to convert operating cash flow to free cash flow. It is essentially how much of your sales turn into free cash flow. FCF is what's left over once your business covers its outflows (costs of business operations and maintenance of capital assets).

In general, however, a CCR of 1 indicates that a business efficiently converts every dollar of net income to cash. A CCR above 1 means that you have high liquidity that you can then use to invest in business growth strategies like marketing, product development, or hiring.

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.

The cash conversion cycle measures the time required for the company to clear out its stored inventory, turn its outstanding accounts receivables (A/R) balance into cash, and how long the payment date to suppliers for goods/services received can be pushed out.