What is cash flow conversion?
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As a business owner, you likely focus on sales. Sales are proof of concept for your product and are the best way to get your brand into the marketplace. Not to mention that when you are running a company, you want as much money coming in as possible.
But what if your sales skyrocket and you're still unable to buy inventory? What if those operating expenses—leases, payroll, keeping the lights on—are costing you more than those enviable sales can cover?
That’s when your free cash flow conversion rate comes in. This tells you not just how much cash is coming through the door but how much of that cash you can use for other goals. Cash flow conversion isn’t just handy to know. It’s vital to the health of your business.
Thankfully, if your free cash flow conversion rate is less than ideal, there are many ways you can improve the number. Reducing operating expenses is one of the easiest and most effective ways to improve cash flow conversion. If you're running a business, spend tracking features make this job a snap.
What is free cash flow conversion?
Your free cash flow conversion is exactly that—how much of your sales turns into free cash flow. It’s what’s left over once your business pays for its operating costs and maintenance of capital assets.
To figure out your cash flow, you have to start with some basic numbers. Of course, you’ll need to understand your operating budget—but more precisely, you need to understand how much money the business spends each month clearly.
From there, you can see how much your cash flow is in line with your goals—or in need of a boost through some cost-cutting and restructuring efforts. If you know how to track business expenses, you’re off to a great start.
How to calculate free cash flow conversion using the cash conversion ratio
There’s another step past knowing the free cash flow conversion—understanding its relationship to income. Knowing how much available cash is helpful, but do you know how much revenue the business had to generate to get that cash?
That’s where the cash conversion ratio (CCR) comes in. The CCR is equal to the cash flow from operations divided by the net profit. You can get these figures from your financial statements.
It helps to know not only your free cash flow (FCF) but your earnings before interest, taxes, depreciation, and amortization (EBITDA). These are two different ways of analyzing the earnings of a business.
Free cash flow is earnings plus depreciation and amortization expenses, less changes in working capital and capital expenditures.
EBITDA is earnings before accounting for essential expenses like interest payments, tax payments, amortized capital expenses, and depreciation. EBITDA does not take into account one-time capital expenditures.
Free cash flow gives a good indication of the amount of available cash that is running through the business. You can use this figure to calculate your CCR, but you may want to know your EBITDA for a better sense of the overall financial obligations of your business.
Let’s put the cash conversion ratio into context with a few examples.
Cash flow from operations: 100,000
Net profit: 75,000
Cash conversion ratio: 100,000/75,000 = 1.33
Cash flow from operations: 75,000
Net profit: 100,000
Cash conversion ratio: 75,000/100,000 = 0.75
Cash flow from operations: 100,000
Net profit: 100,000
Cash conversion ratio: 100,000/100,000 = 1.0
With this figure available to you, it’s easier to determine if you need a new strategy to manage cash flow or modify your spending patterns in the business.
What does cash flow conversion tell you?
Cash flow conversion is one tool to determine whether your business is using its resources best. It’s closely related to the cash conversion cycle, which is the time it takes for your business investments to return to the company as cash. This is a fluid figure with many influencing factors.
How you interpret the CCR depends on the age of your business and your future growth plans. When you need to spend money to make money, being flush with cash is not always what you want to achieve. A company’s cash flow in a given period relies on knowing net income and is important for forecasting, but it must be understood in context.
A high CCR, or anything above 1.0, means the business has high liquidity. There’s more cash compared to profit. This is more common with older companies, as they have accumulated large cash reserves. For startups or early-stage companies, there may be lower liquidity.
Having too much cash might be good news—or it may mean a company is under-investing in its growth. Management might consider putting some of its available cash into new strategies to create new opportunities for the operation.
The CCR also gives investors some way to determine whether the company is a good bet. High liquidity means a company can probably pay strong dividends when the time comes. This makes the business a more attractive opportunity for those looking to buy shares. Investors may take this into account when determining the valuation of the business.
For early-stage businesses, CCR can also provide insight into cash flow problems that may fly under the radar. This gives companies time to fix some operational issues in order to keep the business running. Working capital management is important for a company’s ability to pivot and adjust as new challenges arise.
How to put cash flow conversion in context
As useful as cash flow conversion may be, it is only a snapshot of a business's financial health. It also only tells part of the financial picture; a company with poor cash flow might actually be on stronger footing than one with lots of cash at the moment.
For example, there may be two very different businesses that have the same CCR. One that has product ready to sell may be able to boost its cash flow more quickly than one that is still manufacturing goods. Knowing the full story behind a business is essential.
Low cash flow doesn’t always mean a business is about to go under. On the contrary, some businesses with little cash flow may actually be putting their money behind new growth opportunities. The metric may not reflect what they are doing to invest in ways that affect working capital. These may take some time to reflect in the cash flow coming into the business.
Investing in inventory may also take a chunk out of free cash flow, but as that product sells more of that investment will turn into cash that feeds the balance sheet of the business. Changes in financial assets and liabilities of the business, like depreciation and amortization, can make this figure go up or down accordingly.
The ratio, therefore, is an important way of seeing how the accounting aspects of your company work together—but it’s also essential to know what’s going on in real time with day-to-day business.
How to quickly improve cash flow conversion by controlling expenses
Companies can also make this ratio better simply by reviewing how much money goes out of the business. Expenses are inevitable, but there are usually ways to reduce costs and improve cash flow from operating activities.
Businesses might consider looking at their tail spend and doing an overall spend analysis to make sure they’re not draining free cash flow in ways that are unnecessary, especially in the early stages of business growth.
There are other ways you can help to improve your company’s financial picture, such as:
- Encouraging on-time payments from customers through contract clauses and reminder notices
- Managing inventory levels so you don’t over-invest in a product—high inventory turnover, as long as you can keep up with sales, means your investments are working for your cash flow
- Taking a close look at sales and focusing your efforts on successful products
- Streamlining your invoicing process so you get quicker payment for goods and services
- Overhauling your accounts payable and accounts receivable to reduce the money you spend on late fees and decrease the amount of time it takes for your customers to pay you
Try to find ways to reduce operational costs. You can start by taking a hard look at your spend management, otherwise known as spend control. This not only lets you see where your cash is going every month, but it helps you identify ways to fix holes in your accounting system. For example, you can develop clear guidance for team members on what is acceptable spending and implement approval procedures for expenditures.
Take control of your expenses with Ramp
Cutting costs is often an effective strategy to improve business cash flow. With the right technology, you can make this task even easier.
Ramp's financial management software is just what you need to support the lifeblood of your business. Our tools include spend control measures that give the right employees agency over their spending—while you monitor the limits and discretion in real time.
We help you set a balance between letting your people do what they need to in order to grow the company without issuing them a blank check or empty credit card.
Expense policies give you that flexibility while allowing you transparency and control over where your business’s money goes. Our automated savings insights show you where you could cut back on your cash outlay—simply and easily.
Ready to learn more? See how Ramp can work for you.