October 21, 2021

How the Cash-Flow Conversion Ratio Can Boost Business Liquidity

David Rodeck

Financial Copywriter, David Rodeck LLC

Cash is king when it comes to running a business. While making sales and earning profits is important for your long-term success, if you don’t have money on-hand you might struggle to restock inventory, pay your business lease or mortgage or make payroll. Cash-flow trouble can sneak up on you, especially if you don’t have time to analyze every part of your financial statements.

For a quick view of where you stand, you could use the cash-flow conversion (CFC) ratio. This is a short, one-step calculation that shows whether you’re in good shape or if there could be some problems in your business model. Here’s what to know about this ratio and how you can use it effectively.

What Is the Cash-Flow Conversion Ratio?

Cash-flow conversion measures how efficiently you turn your sales and profits into actual cash. If you aren’t careful, it’s possible to make a lot of sales and in theory run a profitable business, but still run into financial trouble because of cash-flow issues. For example, if customers don’t pay their invoices on-time, you may struggle to pay your own bills.

Sixty percent of business owners report having cash-flow trouble at some point and it’s one of their top three causes of stress (along with decreasing sales and not getting paid properly), according to a 2021 QuickBooks survey of 3,500 small-business owners of companies with 100 or fewer employees.

“A rise in revenue without a rise in the cash conversion rate may mean that we do not have a good strategy for profitability,” says Ben Wallington, CEO of Designerwear. “It could also mean that we have too much money tied up in the functioning of the company. Either way, this ratio is a great way to measure the liquidity of your business.”

How Do You Calculate Cash-Flow Conversion?

The formula for the cash-flow conversion ratio is cash flow from operations divided by net profits. Cash flow from operations is the total amount of money gained or lost as a result of running your business, things like making sales and paying your employees.

For this calculation, you should ignore the cash-flow impact of investments, like buying or selling long-term equipment, as well as financing, like taking out a business loan, because your focus is on the efficiency of your day-to-day operations.

Your net profits are what you have left over from your revenues after subtracting expenses, cost of goods sold, depreciation and taxes. For example, if your operating cash flow for the last quarter was $1 million while your net income was $1.2 million, your cash-flow conversion ratio would be .83 ($1 million/$1.2 million.)

What Is a Good Cash-Flow Conversion Ratio?

A perfectly efficient cash-flow conversion ratio would be at one exactly. This means that you’re turning every dollar of net income into cash during your accounting period. Real life rarely works this smoothly, so chances are your result will be greater than or less than one.

If your ratio is significantly less than one, that shows a potential liquidity problem as you aren’t turning all your profits into cash. Alternatively, a ratio above one means you have a lot of liquidity, perhaps because clients are prepaying their invoices or you’ve been able to delay expenses. It could be a sign that you should invest that idle cash to grow your business.

“When we were in our startup phase, our ratio was low due to the amount of capital required to invest in our business. However, as we have matured our ratio has become higher as we have accumulated more cash,” says Brad Touesnard, founder and CEO of SpinupWP.

What Are the Pros and Cons of This Calculation?

The main advantage of the cash-flow conversion ratio is its simplicity. You only need to pull a couple of numbers from your financial statements and can gain some valuable knowledge about your business. It’s particularly useful for newer companies that are expanding, because they can have cash-flow problems sneak up on them. By checking your ratio regularly, you can catch them earlier.

With that being said, it should not be the only financial point driving your decisions. “I believe the CFC ratio provides some insight, but when digging into how it’s calculated, there are many flaws that can hinder operating and investment decisions,” says Dr. Reginald Tomas Lee, a business analytics professor at Xavier University.

For example, a company with a lot of finished product ready to sell would be in a stronger position than one with only raw materials and very little inventory for sale. “Two companies with the same CFC can have very different liquidity. It’s not the numbers, it’s what’s behind the numbers,” he says.

That’s why you should still know how to review all your financial statements beyond cash flow to get a full picture of your business’s financial health.

How Can You Improve Your Cash-Flow Conversion?

If your cash-flow conversion ratio is not where you want it to be, there are a few ways to turn it around:

Pay more attention to invoices.

If you aren’t tracking your customer invoices, you could be behind on collections without knowing. If your ratio is too low, pay close attention to who is behind on payment so you can send reminders.

Encourage on-time payment.

Chris Alexakis, co-founder of Cabinet Select, also recommends motivating your customers to pay by offering discounts for early payment and penalties for being late. “Positive and negative reinforcement can encourage customers and clients to be diligent in settling their balances. Without any rewards or consequences, people might not be motivated to perform specific actions,” he says.

Automate receivables.

If you find you don’t have the time to pay attention to your receivables and that’s why you don’t collect, consider automating the process using software, which could save you money.

Improve inventory turnover.

You can’t pay your bills with unsold inventory. If your cash-flow conversion ratio is too high, check your inventory supplies to see if some products aren’t selling well or if you’re stocking up too much, so you can preserve your cash. You could also switch to a “just-in-time” inventory management system to shorten how long you hold onto goods before selling.

Slow down expenses.

In a cash crunch, consider where you can temporarily slow down spending, like paying your bills at the last minute or delaying an equipment purchase until the next accounting cycle. This would give your cash flow time to catch up.

Better cash flow is possible if you pay attention to it. By checking your cash-flow conversion ratio frequently and using these strategies, you can help put your business in a stronger financial position.

Photo: Getty Images