Cash Conversion Ratio

What the ratio reveals

A ratio of 1.0 means each dollar of net income shows up as a dollar of operating cash. Above 1.0 means cash is being generated faster than profit is being recognized — common in mature businesses with stable working capital and significant non-cash depreciation.

Below 1.0 means profit is being recognized faster than cash is being generated. Often the cause is growth (working capital absorbing cash) or aggressive accounting. A ratio persistently below 0.7-0.8 with no growth justification deserves investigation.

Reading multi-year trends

Single-year cash conversion can be distorted by timing (a big customer paid in early January instead of late December). Three-year averages give a cleaner signal. Public-company analysts compare the ratio against industry peers — software companies often run above 1.0, project-based service businesses around 0.8-1.0, capital-intensive businesses below 1.0.

When evaluating an acquisition or a partner business, the cash conversion ratio is one of the first checks. A target with great EBITDA growth but a deteriorating CCR is often hiding accounts receivable build-up that the acquirer will inherit.

What a low CCR is telling you

A cash conversion ratio (CFO ÷ net income) below 0.7 sustained over multiple periods is one of the more reliable warning signs in financial analysis. The earnings are real, but the cash isn't materializing — usually because working capital is expanding faster than profit, capex is being underreported, or revenue recognition is running ahead of collection.

The fix depends on the cause. If working capital is the issue, attack DSO, DIO, and DPO directly. If capex is the issue, recognize that maintenance capex is a real ongoing cost and either reduce the asset base or accept lower owner distributions. If revenue recognition is the issue, you may have a deeper problem with how the business is keeping score.

Healthy mature businesses convert 90-110% of net income to cash flow from operations on average. Above 100% means the business is shrinking its working-capital footprint (often because growth has slowed). Below 70% for an extended period merits a forensic look, even if the income statement looks great — many publicly disclosed accounting frauds were first identified by analysts who noticed that reported earnings were not converting to cash.

The CCR also matters for owner distribution decisions. If you're consistently distributing 90% of net income but only converting 70% of net income to cash, you're funding distributions out of working capital — a path that ends in either a credit line draw or a covenant breach. Distribution policies should be tied to trailing CCR, not just to reported earnings.