Monday 13 May 2024

Quality of company's profits. Operating cash conversion ratio.

Operating cash conversion ratio

Operating cash conversion = (operating cash flow / normalised EBIT) x 100%

(EBIT = operating profit)

This ratio gives the investor an insight into the quality or otherwise of a company's profits.  Ideally, we want to see a company consistently turning all its operating profits into operating cash flow.  This will be reflected by an operating cash conversion ratio of 100% or above.

Not only does this make a company's profits more believable but also it means that it will have a stronger financial position - and less need to borrow money - than a company that has to wait for some of its profits to turn into cash.


EBIT

+ Depreciation & Amortization

+/-  Profit on disposals

+/-  Change in working capital

- Tax paid

= Net cash from operations


The 2 components needed to calculate the operating cash conversion ratio are:

  1. the operating profit (EBIT), and
  2. the operating cash flow (Net cash from operation)

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