Cash Conversion Ratio: a Worked Example

EBITDA is built on accruals. A sale counts when it is made, not when the customer pays; stock bought for next season counts only when it is sold. That is the right way to measure how a business performs and an unreliable way to measure what it can pay a bank this year, because interest and principal leave the bank account, not the income statement. Cash conversion is the bridge between the two numbers.

A gap is not in itself a warning. A business that grows needs more debtors and more stock to carry higher sales, and some of that absorption is the cost of growth a lender has agreed to fund. The ratio's job is to make the gap visible and put a size on it, so that the conversation turns to what is holding the cash, and whether it comes back.

Three choices change the answer. The first is the denominator. Lenders tend to use EBITDA because it is the earnings figure the debt was sized on; equity analysts often use net profit. The second is where interest sits. Cash flow before interest is the like-for-like comparison with EBITDA, but accounts have not shown interest consistently: IAS 7 has let companies reporting under IFRS classify interest paid as operating or financing. IFRS 18, adopted as NZ IFRS 18 and AASB 18 and endorsed for use in the UK, removes most of that choice for annual periods beginning on or after 1 January 2027 (later for some Australian not-for-profit and superannuation entities). Accounts under other frameworks, such as the UK's FRS 102, follow their own rules. A lender restates every year to one basis before comparing them.

The third is capital expenditure. The plain ratio leaves it out, so a business that capitalises development or maintenance spending moves that cash into investing and raises its EBITDA by the same amount, and the plain ratio improves while the cash is unchanged. Free cash conversion catches what the plain ratio misses. The plain ratio falls only where a capitalised cost is still paid out of operating cash flow while its charge sits below EBITDA, as with some capitalised contract costs.

A furniture maker that sells mainly to retailers, constructed for this page like every figure on it, reports three years of rising earnings. Operating cash flow is shown before interest, in US$m.

The third year's cash flow, walked from EBITDA, shows where the money went:

On earnings, the business covers its debt service more than twice. On cash it covers it a quarter over, and the difference is two decisions. The debtor movement is a concession to one retail customer, which stays in the balance sheet until the terms are renegotiated or the customer goes. The stock is a bet on a range that has not yet sold, which returns as cash if it sells and becomes a write-down if it does not. The lender's file turns on which of the two it is lending against. The debt service figure is the example's, chosen to show the gap, not a level a lender would set.

The ratio is a result, and it needs explaining. Working capital days are the first explanation. The cash conversion cycle breaks the absorption into debtor, stock and creditor days, and in the example the debtor days for the largest customer account for more of the year's shortfall than anything else. Debtor days by customer, from the aged receivables, show whether one account or the whole ledger is slowing.

Free cash conversion is the second. If the furniture maker also spent US$1.0m on machinery in year three, its free cash conversion was 38% ((5.0 − 1.0) ÷ 10.5). The third is the opposite case: conversion above 100%. A business whose sales are falling collects its debtors and runs down its stock, and converts handsomely while it shrinks. A high ratio says the cash arrived. It does not say the business is healthy.

DEFINED IN ONE PARAGRAPH → · THE CASH CONVERSION CYCLE, WORKED → · CASH FLOW ANALYSIS FOR LENDING →

It decides how much of the EBITDA a lender is prepared to borrow against. A business with steady conversion can be lent to on its earnings with some confidence that the cash will follow; one whose conversion is falling is lent to on its cash, which is a smaller number. It also decides the shape of the facility. Cash tied up in a slower customer is a permanent need until the terms change, and belongs in working capital that is planned for, not in a term loan sized on earnings. Stock built for a launch is temporary if the range sells, and a lender may fund it with a facility that must come down when it does.

And it decides what the lender asks to see. A file where conversion has fallen for two years carries conditions that would be unnecessary in a file where it has not: aged debtors and stock reports with the monthly accounts, a covenant tested on cash rather than earnings, and a question at every review about the line on the cash flow statement that moved.