By James Bell
Cash Conversion Ratio (CCR) is a liquidity measure that compares the cash generated by a company compared to accounting profit in a given period. You may also hear this metric called the Cash Conversion Rate. It is often used in manufacturing type industries. We can understand the financial health of a company using CCR. This metric sounds very similar to the Cash Conversion Cycle but the two formulas are very different.
We’re often looking for a healthy rate close to 1. A rate above 1 tells us that we see great liquidity. Below 1 equates to weak or poor liquidity and negative means that the company is incurring losses in the form of negative cash flows or negative net income.
= Free Cash Flow
= Net Income
Click on the link for a more thorough description of Unlevered Free Cash Flow. You could also use Cash Flow Before Interest and Taxes (CFBIT). CFBIT could give you a better idea of the liquidity stemming from operational performance.
You may also see Earnings Before Interest and Taxes (EBIT) here and you can find this on the income statement. It’s important to be consistent in both parts of the equation because you will want to see the true performance changes in CCR over time.
As we discussed earlier, a negative CCR is not good. Yet not all companies are in the same industry nor at the same level of maturity. It’s not uncommon to see start-ups with negative cash flow and negative net income with high valuations. This metric may not be the best way to gain insights into these types of companies.
Because we are dividing 2 numbers, if both are negative the resulting value is positive. Don’t confuse this with the same CCR as a company where both parts of the equation are positive. While outliers like this are technically possible, we trust that you will use common sense and a robust analysis when making judgments on the financial health of an entity.
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