Free cash flow conversion is a liquidity ratio used by both investors and the management team to manage cash flow effectively.
Imagine your company has sales that skyrocket, but on the other hand, the company does not have enough funds to pay debts, run the business, and cover expenses.
Here is free cash flow conversion tells us about a company’s effectiveness in converting its profit into cash.
In this article, I’ve included everything related to FCF conversion. So if you want to learn about what FCF conversion is, its formula, how to calculate it, and how to improve it, then you will like this post.
What is free cash flow conversion
Cash flow conversion is a liquidity ratio that measures the company’s ability to convert net profit into free cash flow. In other words, it compares the company’s free cash flow to its profit.
It shows how much available cash a company has related to its generated profit. Because it’s possible for a company to generate high profit but not have cash.
For example, when a customer buys products on credit, it will be calculated as sales and included in revenue, but the company will not receive actual cash on hand. This increases accounts receivable (money a company is owed).
While offering credit is common, in a large scale, it can lead the company’s cash flow in a negative direction, and the company may face difficulties to paying its suppliers, expenses, and other bills.
Here, free cash flow conversion shows how effectively a company converts its profit into cash. By tracking this ratio, the management team can take steps for better performance.
Fact: Cash is the lifeblood of the business.
Calculate Free Cash Flow Conversion
To calculate free cash flow conversion, you should understand some basics:
The cash flow statement is a financial report which divided into three parts:
- Operating activities
- Investing activities
- Financial activities
Operating activities are crucial for understanding free cash flow conversion, encompassing activities related to the company’s core business, such as generating cash from selling products and paying employee salaries.
All activities considered in free cash flow conversion are located in this section, and the net cash flow of this section is called operating cash flow.
Free Cash Flow: Free cash flow is a more accurate version of operating cash flow. Subtract the value of capital expenditures (capex) from operating cash flow to find out free cash flow.
Formula:
\text{Free Cash Flow} = \text{Operating Cash Flow} - \text{Capital Expenditures}
Free cash flow provides a more accurate view of how much cash the company has available to expand the business. You can use cash flow instead of FCF.
Net Profit: Net profit is the company’s earnings from selling its products and services. It can be calculated by subtracting the cost of goods sold from revenue.
Formula:
\text{Net Profit} = \text{Revenue} - \text{COGS}
You can also calculate and use EBITDA instead of net profit. Both are the same. To calculate EBITDA, add depreciation and amortization back into the net income.
Formula:
\text{EBITDA} = \text{Net Income} + \text{Depreciation and Amortization}
Note: All these values can be found in the cash flow statement.
Free Cash Flow Conversion Formula
FCF conversion is measured by comparing free cash flow to a company’s net profit. To calculate FCF conversion, divide free cash flow by the company’s net profit.
Free Cash Flow Conversion Formula:
\text{FCF Conversion} = \frac{\text{Free Cash Flow}}{\text{Net Profit}}
Another option is:
\text{FCF Conversion} = \frac{\text{Free Cash Flow}}{\text{EBITDA}}
Note that free cash flow conversion is represented in percentage form:
\text{FCF Conversion \%} = \text{FCF Conversion} \times 100
FCF Conversion Example
Imagine a company that manufactured plastic bottles had a net profit of $1.2m, and free cash flow was $1m last year. Now calculate the ratio:
\text{FCF Conversion Rate} = \frac{1m}{1.2m} = 0.83
This indicates the company’s ability to convert its net profit into cash is 83%.
A higher number is good, while a lower number means the company’s cash is stuck in accounts receivable, which is a bad signal.
What FCF Conversion Ratio Tells
The ideal number for any company is a free cash flow conversion ratio of 1 or 100%. However, it’s nearly impossible to achieve this. Most mature organizations have around these numbers.
If it is much less than one, the company’s management team needs to address it promptly as it indicates a lack of cash even after significant sales are generated.
Conversely, if it’s nearly 1, the company is in good shape and can use the cash to invest in opportunities.
Some companies may have a higher than 1 FCF conversion rate due to customer-prepaid services. For example, a company like Finmark, providing cash flow software, might have users who buy annual subscriptions that are prepaid.
Having too much cash is not always a good thing; it may mean the company is not investing cash to expand the business and ensure future growth.
Conversely, a lower FCF conversion is not always bad. Most startups invest heavily in equipment and assets.
Importance of FCF Conversion
The FCF conversion ratio holds significance in several ways, and I’ve highlighted some key points here:
1. Accuracy and Reliability:
The FCF conversion ratio utilizes free cash flow, making it a more accurate and reliable measure compared to other ratios for assessing a company’s performance.
Its simplicity also reduces susceptibility to manipulation by accounting methods, making it a preferred tool for many investors.
2. Management Insight:
Management teams use this formula to gauge the company’s financial health. A high Free cash flow conversion ratio indicates ample cash, enabling the company to address various needs such as debt repayment, dividend payouts, and seizing opportunities.
Conversely, a low ratio signals issues in cash flow activities, easily identified through analysis of the cash flow statement.
3. Investor Decision-Making:
Investors rely on the FCF conversion ratio when deciding where to invest. A high ratio suggests efficient cash flow management and a greater likelihood of a positive return on investment (ROI).
Conversely, a low FCF conversion ratio implies potential financial challenges, indicating higher investment risk.
4. Industry Performance Comparison:
Comparing a company’s FCF conversion ratio within its industry provides insights into its ability to take on debt.
For instance, if Company A has a $1 million debt at a 60% FCF conversion rate and Company B has a 70% rate, it indicates that Company B can handle a $1.2 million debt more comfortably.
Conclusion
Free cash flow conversion is a simple yet effective formula for understanding a company’s financial condition. While it can stand alone, combining it with other financial ratios enhances accuracy.
Here is my definitive guide on the cash flow statement. Must read it. It will significantly enhance your financial knowledge.
I hope you find this post insightful. share your thoughts in the comments below.