The ratio of the cash flow of a company to its net profit
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What is the Cash Conversion Ratio (CCR)?
The Cash Conversion Ratio (CCR), also known as cash conversion rate, is a financial management tool used to determine the ratio of a company’s cash flowsto its net profit. In other words, it is a comparison of how much cash flow a company generates compared to its accounting profit.
Understanding Cash Conversion Ratio Calculations
When calculating CCR, cash flow is the center of the equation. It is used to determine all cash generated in a given financial period – often quarterly or annually, depending on the company’s accounting cycles.
Cash Flow is generally broken down into three categories:
- Operating activities – Cash generated from the operation of the business
- Investing activities – Covers all purchases and sales of long-term investments and assets
- Financial activities – Covers all transactions related to raising (or repaying) capital
In this case, we want Cash Flow from Operations, orFree Cash Flow(which is equal to operating cash flow minus capital expenditures).
Once cash flow is determined, the next step is dividing it by the net profit. That is the profit after interest, tax, and amortization. Below is the cash conversion ratio formula.
The resulting ratio from this calculation can be either a positive value or a negative value. It can be summarized as: if the ratio is anything above 1, it means that the company possesses excellent liquidity, while anything below 1 implies a weak CCR. Anything negative suggests the company is incurring losses.
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Takeaways
Below are some of the takeaways from calculating the Cash Conversion Ratio of a given company.
1. CCR is a quick way to determine the disparity between a company’s cash flow and net profit
A high cash conversion ratio indicates that the company has excess cash flow compared to its net profit. For mature companies, it is common to see a high CCR because they tend to earn considerably high profits and have accumulated large amounts of cash.
In contrast, companies in the start-up or growth stage tend to have low or even negative cash flows due to the required amount of capital invested in the business. In early stages, companies often find themselves earning negative profits until they reach a break-even point, thus the CRR of these companies would also be negative or low.
2. It is a tool for management decisions
While a high CRR could be a good sign for liquidity, having too much excess cash might imply that the company is not utilizing its resources in the most effective way. The company should consider re-investing in profitable projects or expanding its operations to further enhance the profitability of the business.
When the ratio is low or negative, it could be an indication that the company needs to adjust its operations and start figuring out which activities are sinking its income or whether it needs to expand its market share or increase sales in favor of revamping cash flows.
3. It is an investing indicator tool
To investors, what matters is whether a given company is generating enough cash flow to provide a solid return per share. Thus, significant investment opportunities will offer a higher ratio, while a weak investment will show a lower ratio.
However, some companies may dubiously try to alter the ratio, especially the cash flow part, to attract investors. That’s why proper scrutiny of the books of accounts should be conducted first before making an investment decision based on CCR.
Terms Related to Cash Conversion Ratio
There are familiar terms that look similar to the cash conversion ratio, but they carry a different meaning. They include:
Cash conversion cycles (CCC)
CCC is used for measuring management effectiveness by determining how fast a company can convert cash inputs into cash flows over a given production and sales period.
Conversion cycle
In portfolio management, it is used to determine the number of the common shares which a company has been receiving at a specific time of conversion of each convertible security. That is the ratio of per value of convertible bond divided by the conversion price of equity.
Other resources
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FAQs
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.
What is a good cash conversion ratio? ›
What Is Considered a "Good" Cash Conversion Ratio? Depending on the particular industry your enterprise is in, a good CCR will differ. In general, however, a CCR of 1 indicates that a business efficiently converts every dollar of net income to cash.
What is a good cash flow conversion rate? ›
A “good” free cash flow conversion rate would typically be consistently around or above 100%, as it indicates efficient working capital management. If the FCF conversion rate of a company is in excess of 100%, that implies operational efficiency.
What does cash conversion tell you? ›
The cash conversion cycle (CCC), also called the net operating cycle or cash cycle, is a metric that expresses, in days, how long it takes a company to convert the cash spent on inventory back into cash from selling its product or service.
What is another name for cash conversion ratio? ›
The Cash Conversion Ratio (CCR), also known as cash conversion rate, is a financial management tool used to determine the ratio of a company's cash flows to its net profit.
What is a bad cash ratio? ›
A cash ratio equal to or greater than one generally indicates that a company has enough cash and cash equivalents to entirely pay off all short-term debts. A ratio above one is generally favored. A ratio under 0.5 is considered risky because the entity has twice as much short-term debt compared to cash.
Is 0.5 a good cash ratio? ›
Anything above 1.0 shows that a company can pay off outstanding debts and still have a surplus of cash left. There is no ideal figure, but a cash ratio is considered good if it is between 0.5 and 1.
What is a healthy cash conversion cycle? ›
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.
What is the ideal cash flow ratio? ›
Operating Cash Flow Ratio Analysis
Generally, a ratio over 1 is considered to be desirable, while a ratio lower than that indicates strained financial standing of the firm.
What is a healthy price to cash flow ratio? ›
A good price-to-cash-flow ratio is any number below 10. Lower ratios show that a stock is undervalued when compared to its cash flows, meaning there is a better value in the stock.
What Is a Good Cash Conversion Cycle? Generally speaking, a shorter cash conversion cycle is better than a longer one because it means a business is operating more efficiently.
What is the formula for cash conversion? ›
Cash Conversion Cycle = DIO + DSO – DPO
Where: DIO stands for Days Inventory Outstanding. DSO stands for Days Sales Outstanding. DPO stands for Days Payable Outstanding.
How to reduce cash conversion cycle? ›
Regardless of your situation, consider the factors below to reduce your cash conversion cycle effectively.
- Optimize your inventory. ...
- Encourage quicker payment. ...
- Extend days payable outstanding. ...
- Adjust accounts payable periods. ...
- Implement automated software.
The CCR is an important metric that helps investors, analysts, and stakeholders to assess the company's financials and sustainability. A high CCR indicates that the company is efficient in converting its resources into cash and can meet its financial obligations on time.
What is an example of a conversion ratio? ›
For example, one bond that can be converted to 20 shares of common stock has a 20-to-1 conversion ratio. The conversion ratio can also be found by taking the bond's par value, which is generally $1,000, and dividing it by the share price.
What is the cash ratio method? ›
To calculate the cash ratio, divide the amount of cash into your bank accounts by the number of your short-term liabilities. A company's short-term liabilities include accounts payable, short-term loans, and other obligations that must be repaid within one year.
What is a good cash to cash ratio? ›
Although there is no ideal figure, a ratio of not lower than 0.5 to 1 is usually preferred. The cash ratio figure provides the most conservative insight into a company's liquidity since only cash and cash equivalents are taken into consideration.
Is a 7% conversion rate good? ›
Generally speaking, an average lead conversion rate is around 7%. If your company has a rate of more than 10%, you are sitting in a good position. Anything under 3% is a poor rate.
Is 3% a good conversion rate? ›
But here's the thing: That's actually very good. In fact, a “good” website conversion rate falls between 2% and 5% across all industries.
Is 12% a good conversion rate? ›
A good conversion rate is higher than 10%, with a small percentage of businesses obtaining 11.45% on average, while this number varies based on industry and channel.
