Many businesses strive to turn a profit, using their profitability as a measure of success. But a profitable business isn’t necessarily a financially healthy one.
Even after a month of cranking out sales, you might check the bank balance and see it’s tighter than you expected. This disconnect comes from how efficiently a business is turning profits into usable cash.
That’s why finance teams track free cash flow conversion, a metric that helps you understand how effective a business is at turning earnings into usable cash. Read on to learn the definitions and formulas of free cash flow conversion, plus some actionable tips to improve this financial metric.
What is free cash flow conversion?
Free cash flow conversion is a financial metric that tells you what percentage of a company’s earnings becomes free cash flow.
Understanding free cash flow conversion requires understanding two similar, but different, concepts:
- Free cash flow is the cash left over after a business has covered its operating expenses and capital expenditures. This is the net change in cash generated by operations as opposed to obtained from loans or investments.
- Net earnings measure profitability on an accrual basis. Typically reported as EBITDA (earnings before interest, taxes, depreciation, and amortization), it’s the net profit measured based on when revenue and expenses are incurred, not paid.
Under the accrual method of accounting, it’s possible to generate a positive EBITDA but have negative free cash flow. Some examples of causes include customers paying slowly, debt payments adding up, or high capital expenditures.
Free cash flow conversion bridges the gap between these two metrics by showing how efficiently net earnings are being converted to available cash. If you have a low free cash flow conversion, something in the business is causing a disconnect between on-paper profit and available cash.
Free cash flow conversion formula
The most common free cash flow conversion formula uses free cash flow and EBITDA. Both metrics are input into the following formula, with the result expressed as a percentage:
In smaller, simpler operations, it’s common to use net income in place of EBITDA. Businesses with minimal depreciation expenses or interest expenses from financing would see little change from using net income in lieu of EBITDA.
However, it’s better to use EBITDA if you have it, as it controls for the effects of financing decisions or tax situations. This makes it easier to compare your free cash flow conversion over time or other businesses.
The components of the free cash flow conversion formula explained
Before you calculate your free cash flow conversion, you need to find your free cash flow and your EBITDA. Let’s break down each and where you can find it.
Free cash flow is the cash flow that’s available after all costs are considered. This metric is made up of two parts, both found on a cash flow statement:
- Operating cash flow: The net cash generated by day-to-day business operations, found in the operating activities section of the cash flow statement.
- Capital expenditures (CapEx): The funds a business uses in the acquisition or maintenance of capitalized assets like machinery, vehicles, or intellectual property (IP), found in the investing activities section of the cash flow statement.
To find your free cash flow, simply subtract your capital expenditures from your operating cash flow.
EBITDA is your net earnings before interest, taxes, depreciation, and amortization. It’s used to measure the profitability of a business’s operations, controlling for costs that aren’t operational.
To find your EBITDA, take your net earnings and add back any interest, taxes, depreciation, and amortization costs. All of this information can be found on your income statement.
With both, you’ll have what you need to find your free cash flow conversion.
Steps to calculate free cash flow conversion
With such a simple formula, the main work behind calculating your free cash flow conversion comes from finding the information you need. Follow this step-by-step guide to get the numbers you need and apply the formula:
- Find your operating cash flow: Look to your cash flow statement to find your net cash from operating activities.
- Identify your capital expenditures: You can similarly find your capital expenditures number on your cash flow statement, found under the investing activities section.
- Calculate your free cash flow: Subtract the capital expenditures found in step 2 from the operating cash flow in step 1 to find your free cash flow.
- Calculate your EBITDA: With your income statement, start with your net income and add back any interest expenses, taxes, depreciation, and amortization.
- Apply the formula: Divide your free cash flow by your EBITDA and multiply by 100 to find your free cash flow conversion rate in the form of a percentage.
Free cash flow conversion calculation example
To calculate the free cash flow conversion rate, the finance team of a business collects their income statement and cash flow statement for the last quarter.
With these financial documents, they collect the following information:
- Operating cash flow: $440,000
- Capital expenditures: $90,000
- Net income: $310,000
- Interest expense: $25,000
- Taxes: $95,000
- Depreciation: $60,000
- Amortization $10,000
They start by calculating the free cash flow and EBITDA:
EBITDA= $500,000.
These values can now be put into the free cash flow conversion formula:
Free cash flow conversion = 70%.
The finance team now knows that 70% of net earnings becomes free cash flow and becomes available to use in the business.
What is a good free cash flow conversion rate?
Generally speaking, a “good” cash flow conversion rate is considered to be 80% or greater. However, what constitutes a good free cash flow conversion rate largely depends on the industry and stage of the business.
Capital-intensive businesses like manufacturing, which depends on machinery, will have lower cash flow conversion rates than professional services, which are labor-intensive, but have low CapEx.
Similarly, early stage businesses in a high growth phase will have more capital expenditures as they expand, and may do so on owner or shareholder investment instead of earnings. This would also result in a low cash flow conversion rate.
As a general rule of thumb across industries, a cash flow conversion rate below 50% is a concern and needs a deeper investigation to address it. But always contextualize this metric with the unique considerations of your industry and stage of business development.
Improving free cash flow conversion
If your cash flow conversion rate is lower than your goals or industry benchmarks, there are clear, actionable steps to take to realize the improvements you want to see.
Tighten up your accounts receivable process
One of the best ways to turn sales into positive cash flow is to shorten the time between making a sale and receiving payment. The longer invoices go unpaid, the larger the gap becomes between a sale and the cash in hand.
You can speed up the accounts receivable process by shortening payment terms, offering early payment discounts, and using automated invoice reminders for follow up. Track your days sales outstanding (DSO) metric to measure the improvement.
Manage your inventory more efficiently
For businesses that sell products, inventory that sits is a common drain on free cash flow conversion. Every item that sits on a shelf is money that isn’t available to use in the business.
Look at your past inventory buying practices, identifying times you’ve been overstocked and seasonal trends that should inform your orders. Use this to create an inventory buying strategy.
Consider running a promotion or discounting aging inventory to free up working capital that can be reinvested in the business.
Negotiate better payment terms with suppliers
Just as you want to look at your accounts receivable practices, you should look at your accounts payable practices. But instead of shortening payment times, look for opportunities to renegotiate payment terms such that outgoing money lines up with incoming payments.
For example, if you were a services company that billed every client on the 1st of the month on net 15 payment terms, you would want your outgoing payments to come after the 15th, when you’d expect to be paid by your customers.
Remember, it’s not about delaying payments until the last moment, but negotiating to give you the leeway to pay at a time when you have the cash on hand.
Watch your capital expenditures
Since capital expenditures don’t show up on the income statement, they don’t impact your profitability, at least not directly. But they still impact your free cash flow, meaning it’s worthwhile to analyze them and get critical about their purpose.
Some capital expenditures are about maintenance, like keeping your existing assets operational. Others are about growth, like acquiring a new delivery vehicle to fulfill more orders.
You can do more to manage your growth-based capital expenditures. Think about when these expenses are occurring, timing them so you’re not overinvesting in growth that doesn’t have a high return on investment.
Cut unnecessary operating expenses
Operating expenses affect both sides of the free cash flow conversion equation. They impact both your EBITDA and your operating cash flow.
It’s best practice to review your operating costs for opportunities to trim anything that’s unessential. In particular, look at your recurring costs like subscriptions and leases to eliminate costs that have a monthly effect.
Rather than cutting costs completely, there may be opportunities to renegotiate contracts or consolidate vendors to unlock volume discounts. Any savings you make will improve your profitability and help you convert those net earnings into cash more efficiently.
Use automation to expedite closing the books
The sooner you close the books, the sooner you’ll get a read on your true cash position and adapt your strategy based on your needs.
Automating reconciliation with expense management, accounts payable, and accounts receivable platforms that integrate with accounting platforms reduces manual labor, cutting down the monthly responsibility to a simple review.
Once this information is turned into financial reports, you can check your free cash flow conversion rate and track progress against your goals.
Managing free cash flow conversion with BILL
Tracking your free cash flow conversion rate helps you understand how efficient your business is converting earnings into cash. And as you track it over time, you’ll understand if the business is improving or needs to make changes.
But this metric only has historical meaning, you can only track it once the accounting period is closed. That is, unless you have financial projections giving you insights on the future.
With BILL’s Cash Flow Forecasting tool, you can turn real-time data taken directly from your accounting platform into a cash flow projection for up to 13 months into the future. Use dashboard to track key metrics like Cash In and Cash out, Net Cash Flow, and Cash Balance, predicting the impact of your decision-making.
Now you can get a picture of your future free cash flow conversion and adjust your strategy accordingly. Reach out for a demo to learn more about how BILL’s suite of tools can empower your financial reporting, efficiency, accuracy, and more.
