While making sales and earning profits are important for long-term business success, companies need cash on hand to restock inventory, pay leases or mortgages, make payroll, and more. Yet cash flow trouble can sneak up, especially in smaller companies without the resources to analyze every part of their financial statements.
Thankfully, two simple calculations can help measure a business’ cash management capabilities and reveal potential cash flow problems: the cash conversion ratio (CCR) and the cash conversion cycle (CCC). Here’s what businesses need to know to use these two cash conversion formulas effectively and why these metrics are so important to boost and safeguard liquidity.
Why Are Cash Conversion Metrics Important?
Sixty-eight percent of small businesses report having cash flow problems and rank it as their fourth biggest threat – behind rising costs, the economy, and supply chains, according to a 2022 QuickBooks survey.
Cash conversion metrics measure how efficiently a company manages its cash flow. More specifically, formulas like the cash conversion ratio and cash conversion cycle track how much on-hand cash a company generates from its revenues and how quickly.
If businesses aren’t careful, it’s possible to have high sales and run a profitable business on paper, but still run into cash flow issues that impede operations. Cash flow management can be especially important for businesses that sell goods or services on credit, as they typically need to front the expenses before receiving any revenue – sometimes waiting weeks or even months before recouping those costs. For example, if customers don’t pay their invoices on time, a business could struggle to pay its own bills.
What Is the Cash Conversion Ratio?
The cash conversion ratio, sometimes referred to as the cash flow conversion ratio, measures how efficiently a business can turn its revenues into actual cash. The formula is based on cash flow from operations and net profit.
Cash flow from operations refers to the total amount of money gained or lost as a result of running the business, including measures like incoming cash from sales and outgoing costs from paying wages. It can be found on a company’s statement of cash flows and excludes investing and financing.
Net profit (or net loss) is the income (or loss) that remains after subtracting a company’s total expenses from its total revenue for the financial period. It appears on the bottom line on a company’s income statement.
How Do You Calculate Cash Flow Conversion?
The formula to find the cash conversion ratio is straightforward: Divide cash flow from operations by net profit.
CCR = Cash Flow from Operations / Net Profit
For example, if a business’ last quarter operating cash flow was $1 million, and the net profit was $1.2 million, the CCR would be 0.83 ($1 million/$1.2 million).
Because cash from operations doesn’t include the cash flow impact from investments (such as buying or selling long-term equipment) and financing (taking out a business loan), CCR focuses on calculating the efficiency of day-to-day operations, not long-term financial changes.
What Is a Good Cash Conversion Ratio?
A perfectly efficient cash conversion ratio would equal exactly one. This would mean that every dollar of net income is converted into cash during the accounting period. Real life rarely works this smoothly, so chances are the result may be greater than or less than one and can fluctuate from period to period.
A cash conversion ratio that’s significantly and persistently less than one shows that profits are not efficiently being turned into cash. This can indicate potential future cash flow and liquidity problems. Alternatively, a ratio higher than one points to effective cash conversion, typically due to a quick accounts receivable process or delayed expenses. A consistently high ratio isn’t necessarily a good thing; businesses with high levels of cash on hand may be missing opportunities to invest idle cash in growth.
In application, there is no “perfect” CCR, as some types of businesses may benefit from more efficient cash conversion and, therefore, more liquidity than others. An established subscription service, for instance, has predictable income and may be able to deal with less liquidity than growing startups with tight budgets and unpredictable revenue streams.
What Is the Cash Conversion Cycle?
The cash conversion cycle shows the time it takes between producing a finished good and collecting the cash from a sale. The calculation is a little more complex than the cash conversion ratio but still fairly straightforward.
To calculate the cash conversion cycle, businesses first need to know:
- Days of inventory outstanding (DIO), or the average time inventory sits before it’s sold
- Days sales outstanding (DSO), or the average time it takes for cash to be collected after a sale
- Days payable outstanding (DPO), or how long it takes a business to pay its bills
Once DIO, DSO, and DPO are determined for the period in question, here’s how to calculate the cash conversion cycle:
CCC = DIO + DSO + DPO
Like the cash conversion ratio, the cash conversion cycle should be contextualized with the company’s goals and business model and is often viewed as an overall trend, not a stand-alone number. If the cash conversion cycle is increasing, it could point to inefficiencies that are slowing down operations and obstructing cash flow.
What Are the Pros and Cons of These Cash Conversion Calculations?
The main advantage of the cash conversion ratio and cash conversion cycle formulas is their relative simplicity. Analysts may only need to pull a few numbers from financial statements to gain valuable knowledge about the health of the business. These metrics can be particularly useful for growing companies that may face unexpected cash flow problems even if they’re profitable on paper. By checking these ratios regularly, businesses can spot trends and solve cash flow issues before they hurt liquidity and negatively impact operations.
But these numbers are most useful in a larger context. For example, a company with plenty of finished products on hand may be able to better weather unexpected demand spikes or supply chain disruptions than a company with more raw materials than finished goods, even if they have similar cash conversion ratios and cycles. For volatile markets or industries prone to disruption, strategies such as inventory allocation and demand forecasting may be just as important as managing cash flow, if not more. Therefore, decision-makers can review complete financial statements, not just cash flow metrics, to get a full picture of the business’ financial health.
How Can You Improve Your Cash Conversion Ratio and Cycle?
There are several ways businesses can speed up cash flow and boost liquidity:
- Pay more attention to invoices. The accounts receivable team should consider actively monitor invoice age and collect outstanding payments. In addition, it can help to have customer invoices sent out as quickly as possible and ensure they're accurate. This can streamline the process and prevent unnecessary back and forth with the customer.
- Encourage on-time payment. You can motivate customers to pay on time – or even early – by offering early payment discounts and adding penalties for late payments. This can put cash in your business’ hands sooner.
- Automate processes. If staff can’t keep up with receivables and payables, you can consider automating the process, which could save money and create more streamlined and efficient workflows.
- Improve inventory turnover. You can aim to improve demand forecasting capabilities to better align inventory purchasing process with sales forecasts. If you need to increase cash flow to pay bills, you can also check inventory to see if some products can be sold quickly – perhaps at a discount or bundled with better-selling goods. But this is generally a last resort, as it’s generally better to hone forecasting skills and sell inventory at its full price.
- Slow down expenses. In a cash crunch, you can consider temporarily rethinking your cash management strategies. Temporarily paying bills at the last minute or delaying an equipment purchase until the next accounting cycle, for example, can offer some breathing room while customers pay their invoices and cash flow catches up.
The Takeaway
Better cash flow and improved liquidity can be possible with careful attention to detail. By regularly checking and analyzing simple metrics such as the cash conversion ratio and cash conversion cycle, businesses can assess the strength of their financial position and identify ways to make changes that will support long-term viability.
Images: Getty
A version of this article was originally published on October 21, 2021.
