Last editedJan 20232 min read
When it comes to running a business, it’s important to keep a close eye on your cash flow. Ensuring a healthy cash flow means you’ll be able to pay for inventory and keep the lights on. Beyond the cash flow statement, there are a few additional ways to measure financial performance. Calculating cash flow conversion is one of them, using a simple ratio to see where you stand.
What is the cash flow conversion ratio?
Imagine that your business has a great month on paper, landing several major sales and raking in the profit. However, if there’s a lag between making a sale and getting paid, you could still struggle with cash flow.
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. By comparing free cash flow with profitability, you’ll have a quick snapshot of cash flow generation.
What is the free cash flow conversion formula?
Calculating cash flow conversion is simple. To get started, you’ll need to know your free cash flow (cash from operations – capital expenditures) and EBITDA (earnings before interest, taxes, depreciation, and amortisation).
With those figures in hand, you must use the free cash flow conversion formula:
By looking at this formula, you can see how well your company’s converting EBITDA, or earnings, into free cash flow.
What is a good free cash flow conversion ratio?
If your business is operating at maximum efficiency, the cash flow conversion ratio would be one. That would show that you successfully convert every dollar of net income earned into cash. However, it’s rare for a business to achieve this goal. In most cases, the result will be either higher or lower than one.
Ratio < 1: You aren’t turning all your net profit into cash. This might signify a liquidity problem depending on how low the number is.
Ratio > 1: This means you have excess liquidity, either due to clients prepaying invoices or a lack of expenses. It means you have cash that could be used for investment and growth.
How to calculate free cash flow conversion
To calculate cash flow conversion, use the free cash flow conversion formula given above:
EBITDA is used in this example, but you could use a different measure of profit that suits your business if necessary, such as net profit. For example, EBITDA doesn’t take capital expenditures and changes in working capital into account.
No matter which profitability measure you choose, divide it from free cash flow to arrive at your conversion. This can be expressed as a number or percentage.
The primary advantage of this calculation is its simplicity, giving a quick snapshot of how well you’re using your cash. You’ll be able to spot cash flow problems early, even if your business is just starting out.
How to improve cash flow conversion ratio
If your cash flow conversion ratio is lower than you’d like, it’s time to act. The best way to improve cash flow conversion rates is to encourage on-time payments from customers. Send invoices to your customers as soon as projects are completed, or even ask for a percentage of payment upfront. You can provide incentives for early and on-time payment, including small discounts or giveaways.
It’s helpful to automate the receivables process using accounting software to track outstanding invoices more efficiently. GoCardless integrates with over 300 partners including Xero, Salesforce, QuickBooks, and others – putting automated payment collection into your accounting workflow. Collect recurring invoice payments on the day they’re due with Direct Debit, or one-off payments using our Instant Bank Pay solution. This improves cash flow for a better ratio.
We can help
GoCardless is a global payments solution that helps you automate payment collection, cutting down on the amount of financial admin your team needs to deal with. Find out how GoCardless can help you with one-off or recurring payments.