Cash Conversion Ratio
A financial management metric used to assess the proportion of a company's cash flows to its net profit is the cash conversion ratio, or CCR for short. In other words, it evaluates how much cash flow a business produces in relation to its accounting profit.
Cash flow serves as the focal point of the equation for calculating CCR. According to the company's accounting cycles, it is used to identify all cash created within a specific financial period, which is frequently quarterly or yearly.
Cash Flow is generally broken down into three categories:
- Operating activities – The money that the company makes while it is in operation.
- Investing activities – Includes all acquisitions and dispositions of long-term assets and investments.
- Financial activities – Includes all transactions pertaining to capital raising (or repayment)
In this instance, we're looking for free cash flow or cash flow from operations (which is equal to operating cash flow minus capital expenditures).
After calculating cash flow, the next step is to divide it by net profit. After interest, tax, and amortization, that is the profit.
Different cash flow and profit measurements can be used to compute the cash conversion ratio, but the following method is the most popular:
Cash Conversion Ratio (CCR) = Operating cash flow / EBITDA
Operating cash flows, sometimes referred to as cash flow from operations, are a section of the cash flow statement that shows how much money a business has made from its primary operational activities during a certain time period.
EBITDA stands for earnings that are reported before taxes, depreciation, interest, and amortization.
1. Calculating the discrepancy between a company's cash flow and net profit is easy with the CCR method.
A high cash conversion ratio suggests that the business generates more cash flow than net profit. A high CCR is typical for mature businesses because they typically generate sizably high profits and have amassed sizable sums of capital.
As a result of the substantial amount of capital that must be invested in a start-up or growing company, cash flows throughout these phases are typically low or even negative. Companies frequently have negative earnings in their early phases until they reach a break-even point, hence their CRR would similarly be negative or low.
2. It is a tool for management decisions
While having a high CRR may indicate that the company is using its resources effectively, having too much extra cash may indicate that the organization is not. To further increase the profitability of the firm, the corporation should think about reinvesting in successful projects or growing its activities.
When the ratio is low or negative, it may be a sign that the business needs to make changes to its operations and begin identifying the activities that are draining its income. It may also be a sign that the business has to gain market share or sales in order to improve cash flows.
- The cash conversion ratio (CCR) assesses a company's effectiveness in converting profits into cash by comparing operating cash flows to profitability.
- A high CCR frequently denotes effective working capital management, whereas a low CCR often denotes ineffective working capital management or could imply subpar corporate performance.
- Credit research, business valuation, and leveraged buyouts all make use of the CCR (LBO).