All You Need To Know About FCF Conversion

FCF Conversion or Free Cash Flow Conversion is a liquidity ratio that measures how well a company changes its operating income into free cash flow (FCF) in any given period.

This ratio, along with other metrics, helps to determine the effectiveness of a company’s cash flow generation. As per a study conducted in 2022, 68% of small businesses have reported cash flow issues as one of their top threats.

Let’s address this concern in this blog and learn how to interpret it.

We’ll also talk about another important metric that is directly related to FCF – FCFE or Free Cash Flow to Equity.

What Is Free Cash Flow

FCF is the money generated by a company after considering the cash expenditures required to maintain and advance its capital assets.

FCF is the cash remaining after covering debts and financial obligations, indicating the amount available for creditors’ interest, stockholders’ dividends, debt repayment, and business expansion.

This makes FCF a key indicator of a company’s financial health and operational performance.

It’s worth noting that free cash flow may be defined differently for different companies and may have significant discretionary adjustments along the way.

Recommended Read: Equity Financing vs Debt Financing

Why is Free Cash Flow Essential

People who invest in large organizations use free cash flow as one of several financial metrics to assess the stability of any particular company. 

Investors and creditors use FCF alongside metrics like ROI, quick ratio, debt-to-equity ratio, and EPS to assess a company’s stability.

They also evaluate FCF to determine if a business plan is profitable enough for growth investments.

FCF conversion methods, computed with other financial figures, offer a clearer picture of cash flow, indicating if additional capital is needed or if investments should be made for further growth.

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What is Free Cash Flow Conversion

Free Cash Flow (FCF) Conversion is a ratio that shows how much of a company’s operating profit is converted into FCF within a year.

It measures whether or not a company generates cash from its operations by comparing available free cash flow with an operating metric.

Recommended Read: Operating Profit vs Net Profit

How to Calculate Free Cash Flow Conversion

Computing the FCF Conversion Ratio involves dividing Free Cash Flow (FCF) by Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).

While EBITDA serves as a proxy for operational cash flows, it has been criticized for excluding non-cash costs like depreciation and amortization, which are crucial for assessing actual operating performance and future cash flows.

The formula is:

FCF Conversion Rate = Free Cash Flow (FCF) / EBITDA

where,

FCF = Cash from Operations (CFO) – Capital Expenditures (Capex), and
EBITDA = Operating Income (EBIT) + Depreciation and Amortization (D&A

In essence, free cash flow is cash from business activities minus Capex.

The FCF conversion analysis measures how effectively a company converts its EBITDA into operating cash flow. The FCF conversion rate is typically expressed as a percentage or sometimes as multiples.

Benefits and Limitations of Free Cash Flow Conversion

Benefits:

• Valuation Insight: FCF conversion rate adjusts for changes in working capital, providing a clear view of a business’s value and trends.
• Operational Insights: Changes in accounts payable, accounts receivable, and inventory reflect operational efficiency and cash flow dynamics.
• Investor Perspective: This metric helps investors assess dividend and debt payment capabilities, crucial for financial stability and shareholder returns.

For example, a company records EBITDA at $1,000,000 in one year. The organization has no variations in working capital but purchases new equipment worth $800,000 towards year-end.

This cost of new equipment is allocated to different periods through depreciation on the income statement, which positively affects the earnings of the said company.

Limitations:

• Cash Flow Variability: FCF can fluctuate significantly due to one-time expenses like equipment purchases, impacting short-term financial health assessment.
• Forecasting Challenges: Investors should scrutinize rapid FCF declines and rebounds to understand sustainability and future cash flow stability.

Importance of Free Cash Flow Conversion

• Financial Clarity: FCF conversion rate reveals the actual funds available to a company, critical for financial health assessment.
• Survival Indicator: Continuous low or negative FCF may force a company into costly capital-raising cycles for survival.
• Expansion Potential: Adequate FCF not only sustains current operations but also fuels future growth opportunities.
• Investor Insight: Investors use FCF to gauge dividend prospects and potential future increases from companies.

What is a Good Free Cash Flow Conversion Rate

A good Free Cash Flow Conversion Rate indicates how efficiently a business turns its net revenues into cash.

Ideally, a ratio of 1 means all net revenues become cash, though this is rare. Here’s what different ratios mean:

• Ratio < 1: Not all net profit converts to cash, suggesting potential liquidity issues.
• Ratio > 1: Excess cash, possibly from upfront payments or reduced costs, limiting investment in growth.

This rate also helps investors gauge if a company’s stock price aligns with its actual cash generation.

Calculation methods vary by company and require judgment. Monitoring this rate over time reveals a company’s financial performance trends and improvements.

Recommended Read: Financial Forecasting – A Detailed Guide

How to Improve Free Cash Flow Conversion Rate

To improve the Free Cash Flow Conversion Rate, aim for over 100%. This signifies efficient working capital management, driven by:

• Streamlined Accounts Receivable processes
• Favorable negotiating terms with suppliers
• Increased Demand in the Market Leads to Faster Inventory Turnover

Conversely, a rate below 100% indicates challenges like:

• Delayed customer payments
• Strict supplier credit terms
• Sluggish inventory turnover due to lower demand

Companies often adjust definitions to fit their operational goals, but generally strive for an FCF conversion ratio near or above 100% for optimal financial health.

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