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A company’s cash conversion ratio may be a less familiar financial yardstick than the price-to-earnings ratio or the price-to-book ratio, but it can help investors spot companies that play fast and loose with their accounts.
More positively, it can help identify those that are likely to be able to pay a growing dividend by generating plenty of cash from their operations.
Here, we explain how to calculate the cash conversion ratio, and put it to use.
What does ‘cash’ mean in this scenario?
Before we go into the detail, it’s important to explain what “cash” means in the context of company accounts, and why cash flow matters just as much as the more familiar “profits before tax” (some professional investors say cash flow is actually more important than profit).
For our purposes here, “cash” does not mean banknotes and coins. It relates instead to the flow of payments into and out of a company, and the reason for drawing attention to it is that “profits” and “losses” do not necessarily, by contrast, measure the flow of actual money.
This is a point that may not always be appreciated by private investors. A company could in theory report, quite legitimately, a huge profit while in the same year not receiving a penny of actual money.
Why? Because the income and expenditure reported in a company’s accounts (specifically in the “profit and loss” section, sometimes called the “income statement”) derive from the value of sales invoiced and expenditure invoiced. Cash flow statements, by contrast, report the actual money received from customers and paid to suppliers.
If, say, a company issues a large invoice to its only customer towards the end of its financial year and doesn’t receive payment in that financial year, the invoiced sale is included in the profit and loss account but there is no corresponding cash inflow that year. The result is a big disparity between profits and cash flow.
There are other reasons why reported profits are not always matched by cash inflows. One of the most significant is the way in which the depreciation of a company’s assets is covered in its accounts.
Companies are allowed to count the loss of value of their assets – such as plant and equipment, which occurs naturally over time – as an expense, even though there is no actual movement of money. The consequence is that a company may report a lower figure for profits than for cash flow, if we assume that all invoices issued and received are matched by equivalent movements of cash into and out of the business in the same financial year.
How to calculate a company’s cash conversion ratio
In some of the other articles in this series, such as the one on price-to-earnings ratios, we have been fortunate: while we have explained how to calculate the figures, readers who just want to know what the figure is have been able to find it online. We are not so lucky this time because we have not been able to find any free-to-access sources of cash conversion ratios. Being able to work them out is therefore necessary.
As ever, things can get complicated (one guide from Corporate Finance Institute on financial ratios lists no fewer than five definitions of cash flow), so we will seek to simplify matters as much as possible. We will, however, offer two versions of the cash conversion ratio: one is simple to calculate, while the other is slightly more complex but perhaps more useful in certain circumstances.
The simpler version is calculated by dividing one figure from a company’s accounts by another. The first is the “operating profit” and the second is the “operating cash flow” (sometimes these figures go by other names such as “profit from operations” and “cash generated from operations”).
“Operating profits” are those made before we consider the impact of the interest paid on a company’s debts or earned on its cash. “Operating cash flow” similarly excludes interest payments, as well as cash that flows in and out of a business as assets are bought and sold and certain other transactions separate from its everyday activities.
Cranswick’s operating profits are found in its group income statement on page 140 of its accounts. The figure is £145.9m. We then find the equivalent figure on the group cash flow statement on page 143, where “cash generated from operations” is given as £173.4m.
We now divide the cash flow from operations of £173.4m by the £145.9m figure for operating profits to get a cash conversion ratio of 1.19 or 119pc.
If we want the more comprehensive figure, which takes account of interest and tax, we subtract those two items from both operating profits and cash flow. The income statement tells us that Cranswick owed £28.1m in corporation tax in the year to March 2023. It also had finance costs (interest on borrowings less any interest received on its cash balance) of £6.4m.
Meanwhile the cashflow statement says Cranswick paid £3.8m in interest and paid tax of £20.4m (the figures don’t match those in the income statement because, as we said earlier, there are timing differences between money becoming due and it actually changing hands).
Our profit after interest and tax works out at £111.4m, while cash flow after interest and tax is £149.2m. Dividing the latter by the former gives us a cash conversion ratio of 1.34 or 134pc.
How to use the cash conversion ratio
Cash flow matters because only cash can be spent, not accounting profits. A business that reports profits but generates no cash will find it hard to invest in growth or pay dividends. If investors see a pattern of profits without cash over a number of years, it is a sign that something is wrong.
In some cases astute fund managers have even used an inability to generate cash on the part of supposedly profitable businesses to detect fraud.
Ideally a company will be able to turn all or most of its profits into cash, so a cash conversion ratio of at least 80pc is desirable.
Richard Evans is an investment writer at Fidelity International.
