Cash Conversion Ratio (CCR)

How to Calculate Cash Conversion Ratio (CCR)

The cash conversion ratio, often abbreviated as “CCR” for brevity, reflects the proportion of the net profit generated by a company that becomes operating cash flow (OCF).

The cash conversion ratio compares the reported net income of a company to its cash flow from operations (CFO) in a specified period.

• Net Income → The net income is the profits remaining after subtracting all operating costs (COGS, SG&A, R&D) and non-operating costs (e.g. interest expense, inventory write-down, income taxes).
• Cash Flow from Operations (CFO) → On the other hand, the operating cash flow (OCF) is the net cash produced by the operating activities of a company.

The reason for comparing the two metrics – the net income and cash flow from operations (CFO) – is attributable to the shortcomings of accrual accounting (U.S. GAAP).

In fact, the cash flow statement (CFS), one of the core financial statements, tracks the real movement of cash and reconciles the net income recorded on the income statement based on the cash inflows (“sources”) and outflows (“uses”) in a predefined period.

Therefore, the cash conversion rate illustrates the variance between the accrual-based net income and reconciled operating cash flow (OCF) metrics.

The cash conversion ratio answers the question of, “For each dollar of net income generated by the company, how much of the earnings remain post-reconciliation in operating cash flow?”

The accounting profit, or net income, has become a standardized measure of the overall profitability for publicly-traded companies.

However, the fact that the profit metric has become “standardized” in terms of the established reporting guidelines (and continuous updates to the accounting rules) should not divert attention from the imperfections of the accrual accounting system.

The steps to calculate the cash conversion ratio are as follows:

1. Calculate Net Income
2. Reconcile Net Income to Determine Cash Flow from Operations (CFO)
3. Divide Net Income by Cash Flow from Operations (CFO)

Cash Conversion Ratio Formula

The cash conversion rate formula adjusts the net income prepared in accordance with U.S. GAAP reporting standards by non-cash expenses (D&A) and non-recurring items.

Where:

• 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

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)

The calculation of free cash flow (FCF) and EBITDA can be far more complicated in practice, with discretionary adjustments that tend to be industry-specific.

But irrespective of whichever method is used, the insights derived and takeaways from performing the analysis should be nearly identical, especially if other metrics are related to working capital and capital expenditures (Capex).

For instance, some of the more common metrics include the cash conversion cycle (CCC), capital intensity ratio, and depreciation-to-capex ratio.

• Cash Conversion Cycle (CCC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO)
• Capital Intensity Ratio = Total Average Assets ÷ Revenue
• Depreciation-to-Capex Ratio = Annual Depreciation Expense ÷ Capital Expenditure (Capex)

What is a Good Cash Conversion Ratio?

The cash conversion ratio (CCR) provides insights into the operational efficiency of a company, or more specifically, the current state of its working capital management.

Like many working capital metrics, there is no single “good” cash conversion ratio that all industries collectively target. The recent trend in the ratio relative to historical periods and comparisons to the industry benchmark (i.e. peer group) should provide useful information on the company’s operating efficiency.

However, the cash conversion ratio is also a liquidity ratio since a company generating less operating cash flow (OCF) compared to the net income recognized on the income statement could be a potential risk factor.

Generally speaking, the cash conversion ratio should exceed a minimum of 1.0x from a liquidity risk management standpoint.

In particular, if the underlying drivers causing net income to exceed cash flow from operations (CFO) are tied to inefficient working capital management, the current business model likely needs improvements to avoid the risk of becoming insolvent.

The net income of a company — assuming there are no issues with its capital expenditures (Capex) and M&A strategies — cannot consistently be higher than its operating cash flow (OCF).

Why? The working capital management and near-term reinvestment activity is likely inefficient, which is not sustainable over the long term.

Cash Conversion Ratio Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Cash Conversion Ratio Calculation Example

Suppose we’re tasked with calculating the cash conversion ratio for a company that reported the following income statement data for fiscal year 2023.

The accrual-based net income is $20 million for fiscal year 2023, and we’ll adjust that figure by two items.

• D&A Expense = $6 million
• Increase in NWC = ($2 million)

The D&A expense is treated as an add-back because no real movement of cash occurred (i.e. non-cash expense).

The increase in net working capital (NWC) means more cash is tied up in operations, reducing the company’s free cash flow (FCF).

The cash flow from operation (CFO) section amounts to $24 million.

• Cash Flow from Operations (CFO) = $20 million + $6 million – $2 million = $24 million

Since the cash flow from operations (CFO) and net income of our company is known, the final step is to divide the two metrics, which results in a cash conversion ratio of 1.2x.

• Cash Conversion Ratio = $24 million ÷ $20 million = 1.2x

The 1.2x cash conversion ratio implies that for each dollar of net income generated, there is $0.20 in excess remaining after reconciling for non-cash and non-recurring items.