Skip to main content
diversification.com
← Back to A Definitions

Adjusted cash conversion

Adjusted Cash Conversion: Definition, Formula, Example, and FAQs

What Is Adjusted Cash Conversion?

Adjusted Cash Conversion is a financial metric that measures how effectively a company converts its reported profits, often with specific adjustments, into actual cash from its operations. It falls under the broader category of Financial Metrics used in corporate finance. This metric provides insight into the quality of a company's profitability by examining the relationship between its non-cash accounting profits and the real cash flow it generates. Adjusted Cash Conversion helps analysts and investors gauge a company's ability to generate cash to fund its operations, invest in growth, and service its obligations.

History and Origin

The concept of examining the relationship between profits and cash flow gained prominence with the evolution of financial statements and the recognition of the limitations of accrual accounting. While income statements report revenues and expenses when they are incurred, regardless of cash movement, the cash flow statement provides a clearer picture of actual cash inflows and outflows54.

Formally, the statement of cash flows became a required financial statement in the United States in 1988 with FASB Statement No. 95, superseding earlier "funds statements" that sometimes focused on working capital changes rather than pure cash53. The emphasis on cash flow intensified over time, especially after significant market events. The phrase "cash is king," for instance, gained popularity after the 1987 global stock market crash, highlighting the critical importance of cash in a business's health. More recently, following periods of rising interest rates, the market has placed a significant focus on present cash flow, recognizing its fundamental importance for valuation52.

Key Takeaways

  • Adjusted Cash Conversion assesses how well a company transforms its accounting profits into spendable cash.
  • It offers a clearer picture of a company's financial health and liquidity than profitability measures alone.
  • This metric helps identify businesses with strong operational efficiency and effective working capital management.
  • A higher Adjusted Cash Conversion generally indicates a more financially robust company that can self-fund growth and manage debt.

Formula and Calculation

The term "Adjusted Cash Conversion" can refer to various specific ratios that involve adjustments to profit metrics to reflect cash generation more accurately. One common interpretation, often referred to as the Cash Conversion Ratio (CCR), compares operating cash flow to EBITDA or free cash flow to net income48, 49, 50, 51.

A widely used formula for a form of Adjusted Cash Conversion is:
Adjusted Cash Conversion=Operating Cash FlowEBITDA\text{Adjusted Cash Conversion} = \frac{\text{Operating Cash Flow}}{\text{EBITDA}}
Where:

  • Operating Cash Flow: Cash generated from a company's core business operations. It is found on the cash flow statement and typically includes adjustments for non-cash expenses like depreciation and amortization, and changes in working capital45, 46, 47.
  • EBITDA: Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company's overall profitability before accounting for certain non-operational expenses and non-cash items42, 43, 44.

Interpreting the Adjusted Cash Conversion

Interpreting the Adjusted Cash Conversion provides crucial insights into a company's operational efficiency. A ratio of 1 or greater often indicates that a company is effectively converting its earnings into cash, demonstrating strong cash management capabilities40, 41. For instance, a ratio of 1.0 means that for every dollar of EBITDA, one dollar of operating cash flow is generated.

A higher Adjusted Cash Conversion suggests efficient management of accounts receivable and inventory management, leading to quicker cash collection and reduced cash tied up in operations38, 39. Conversely, a low or negative Adjusted Cash Conversion may signal issues such as delays in collecting payments, excessive inventory, or high operational costs that are consuming cash despite reported profits36, 37. Different industries may have varying benchmarks for what constitutes a "good" ratio, so contextual analysis is essential35.

Hypothetical Example

Consider Company A, a manufacturing business, with the following financial figures for a quarter:

  • Net Income: $500,000
  • Depreciation & Amortization: $100,000
  • Interest Expense: $50,000
  • Tax Expense: $150,000
  • Decrease in Accounts Receivable: $20,000
  • Increase in Inventory: $30,000
  • Decrease in Accounts Payable: $10,000
  • First, we calculate EBITDA:
    • EBITDA = Net Income + Interest Expense + Tax Expense + Depreciation & Amortization
    • EBITDA = $500,000 + $50,000 + $150,000 + $100,000 = $800,000
  • Next, we calculate Operating Cash Flow (adjusting net income for non-cash items and working capital changes):
    • Operating Cash Flow = Net Income + Depreciation & Amortization + Decrease in Accounts Receivable - Increase in Inventory - Decrease in Accounts Payable
    • Operating Cash Flow = $500,000 + $100,000 + $20,000 - $30,000 - $10,000 = $580,000
  • Finally, we calculate the Adjusted Cash Conversion:
    Adjusted Cash Conversion=$580,000$800,000=0.725\text{Adjusted Cash Conversion} = \frac{\$580,000}{\$800,000} = 0.725
    In this hypothetical scenario, Company A's Adjusted Cash Conversion of 0.725 indicates that it converts 72.5% of its EBITDA into operating cash flow. This might suggest some inefficiencies in its working capital management, as less than a dollar of cash is generated for every dollar of EBITDA.

Practical Applications

Adjusted Cash Conversion is a critical metric for assessing a company's financial health beyond just its reported profitability. It is widely used by:

  • Credit Analysts: To understand a company's capacity to generate cash to repay debt and meet short-term obligations33, 34. A company with strong cash conversion is typically seen as less risky.
  • Investors: To evaluate the quality of earnings and a company's ability to generate cash for reinvestment, shareholders returns (like dividends or buybacks), or unexpected expenses31, 32. For example, the importance of strong cash flow generation has been highlighted in periods where "cash is king"30.
  • Management: For internal operational improvements. By monitoring this ratio, management can identify bottlenecks in cash generation, such as slow collection of accounts receivable or inefficient inventory practices, and implement strategies to improve them28, 29.

The metric is especially relevant in sectors where capital intensity is high or where companies frequently sell on credit. Regulators, such as the U.S. Securities and Exchange Commission (SEC), also provide guidance on non-GAAP financial measures, including various forms of cash flow reporting, to ensure transparency and prevent misleading disclosures26, 27. For instance, the SEC staff advises against presenting non-GAAP measures that exclude normal, recurring cash operating expenses necessary for business operations, as this could be misleading25.

Limitations and Criticisms

While Adjusted Cash Conversion offers valuable insights, it is important to acknowledge its limitations.

  • Industry Variations: What constitutes a "good" Adjusted Cash Conversion can vary significantly across industries due to differing business models, capital requirements, and sales cycles24. Comparing companies from different sectors based solely on this metric may lead to inaccurate conclusions.
  • Non-Recurring Items: Adjustments made to derive "adjusted" metrics can sometimes exclude normal, recurring cash operating expenses, potentially presenting a misleading picture of a company's sustainable cash-generating ability21, 22, 23. The SEC has provided guidance on how non-GAAP measures should be presented to avoid being misleading19, 20.
  • Focus on the Past: Like many financial ratios derived from historical financial statements, Adjusted Cash Conversion reflects past performance and does not guarantee future cash generation18. External factors, such as economic downturns or changes in consumer behavior, can significantly impact future cash flows, making forecasting inherently challenging15, 16, 17.
  • Lack of Uniform Definition: The specific "adjustments" made in "Adjusted Cash Conversion" are not always standardized, leading to variations in calculation across companies or analysts13, 14. This lack of a uniform definition can complicate peer comparisons and necessitates careful review of how each company defines its adjusted metrics. Additionally, while corporate cash reserves globally exceed $8 trillion, the effective use and management of this cash, rather than mere accumulation, is critical for long-term financial health12.

Adjusted Cash Conversion vs. Cash Conversion Ratio

The terms "Adjusted Cash Conversion" and "Cash Conversion Ratio" are often used interchangeably or refer to similar concepts within financial analysis. However, "Adjusted Cash Conversion" typically implies a broader or more customized approach, where specific modifications are made to a company's earnings figures to better reflect its true cash-generating capability. The "Cash Conversion Ratio" (CCR) is a more commonly defined metric, often calculated as operating cash flow divided by EBITDA or free cash flow divided by net income9, 10, 11. The key distinction lies in the explicit "adjustment" component: while CCR is a specific form of cash conversion, "Adjusted Cash Conversion" might include additional[1](https://dart.deloitte.com/USDART/home/publications/deloitte/additional-deloitte-guidance/roadmap-sec-comment-letter-considerations/chapter-3-sec-disclosure-topics/3-4-non-gaap-financial-[7](https://dart.deloitte.com/USDART/home/publications/deloitte/additional-deloitte-guidance/roadmap-sec-comment-letter-considerations/chapter-3-sec-disclosure-topics/3-4-non-gaap-financial-measures), 8measures), 2, 34, 56