What is the Free Cash Flow Conversion Rate?
The Free Cash Flow Conversion Rate is a liquidity ratio that measures a company’s ability to convert its operating profits into free cash flow (FCF) in a given period.
By comparing a company’s available free cash flow along with a profitability metric, the FCF conversion rate helps evaluate the quality of a company’s cash flow generation.
- What does the free cash flow conversion rate measure?
- Why might a company pay close attention to its FCF conversion rate?
- Which formula is used to calculate the FCF conversion rate?
- How might you determine whether a company’s FCF conversion rate is “good” or “bad”?
Table of Contents
Free Cash Flow Conversion Rate Formula
The free cash flow conversion rate measures a company’s efficiency at turning its profits into free cash flow from its core operations.
The idea here is to compare a company’s free cash flow to its EBITDA, which helps us understand how much FCF diverges from EBITDA.
The formula for calculating the FCF conversion ratio comprises dividing a free cash flow metric by an accounting measure of profit.
FCF Conversion = Free Cash Flow / EBITDA
Therefore, the FCF conversion rate can be interpreted as a company’s ability to convert its EBITDA into free cash flow.
The output for FCF-to-EBITDA is ordinarily expressed in percentage form, as well as in the form of a multiple.
EBITDA – Proxy for Operating Cash Flow?
In theory, EBITDA should function as a rough proxy for operating cash flow.
But while the calculation of EBITDA does add-back depreciation and amortization (D&A), which are usually the most significant non-cash expense for companies, EBITDA neglects two major cash outflows:
- Capital Expenditures (Capex)
- Changes in Working Capital
To evaluate the true operating performance of a company and accurately forecast its future cash flows, these additional cash outflows and other non-cash (or non-recurring) adjustments are required to be accounted for.
FCF Conversion Rate Industry Comparisons
To perform industry comparisons, each metric should be calculated under the same set of standards.
In addition, management’s own calculations should be referenced, but never taken at face value and used for comparisons without first understanding which items are included or excluded.
Note that the calculation of free cash flow can be company-specific with a significant number of discretionary adjustments made along the way.
Often, FCF conversion rates can be most useful for internal comparisons to historical performance and to assess a company’s improvements (or lack of progress) over several time periods.
Siemens Industry-Specific Cash Conversion Example (Source: 2020 10-K)
Good vs Bad FCF Conversion Rate
A “good” free cash flow conversion rate would typically be consistently around or above 100%, as it indicates efficient working capital management.
A FCF conversion rate in excess of 100% can stem from:
- Improved Accounts Receivables (A/R) Collection Processes
- Favorable Negotiating Terms with Suppliers
- Quicker Inventory Turnover from Increased Market Demand
In contrast, “bad” FCF conversion would be well below 100% – and can be particularly concerning if there has been a distinct pattern showing deterioration in cash flow quality year-over-year.
A sub-par FCF conversion rate suggests inefficient working capital management and potentially underperforming underlying operations, which often consists of the following operating qualities:
- Build-Up of Customer Payments made on Credit
- Tightening of Credit Terms with Suppliers
- Slowing Inventory Turnover from Lackluster Customer Demand
To reiterate from earlier, problems can easily arise because of definitions varying considerably across different companies, as most companies can adjust the formula to suit their company’s specific needs (and announced operating targets).
But as a generalization, most companies pursue a target FCF conversion rate close to or greater than 100%.
Excel File Download
Now, we’re ready to move onto an example calculation of the free cash flow conversion rate. To access the Excel file, fill out the form linked below.
Free Cash Flow Conversion Rate Example Calculation
In our example exercise, we’ll be using the following assumptions for our company in Year 1.
- Cash from Operations (CFO): $50m
- Capital Expenditures (Capex): $10m
- Operating Income (EBIT): $45m
- Depreciation & Amortization (D&A): $8m
In the next step, we can calculate the free cash flow (CFO – Capex) and EBITDA:
- Free Cash Flow = $50m CFO – $10m Capex = $40m
- EBITDA = $45m EBIT + $8m D&A = $53m
For the rest of the forecast, we’ll be using a couple of more assumptions:
- Cash from Operations (CFO): Increasing by $5m each year
- Operating Income (EBIT): Increasing by $2m each year
- Capex and D&A: Remaining constant each year (i.e. straight-lined)
With these inputs, we can calculate the free cash flow conversion rate for each year.
For instance, in Year 0 we’ll divide the $40m in FCF by the $53m in EBITDA to get a FCF conversion rate of 75.5%.
Here, we’re essentially figuring out how close a company’s discretionary free cash flow gets to its EBITDA. Posted below, you can find a screenshot of the completed exercise.
In conclusion, we can see how the FCF conversion rate has increased over time from 75.5% in Year 1 to 98.4% in Year 5, which is driven by the FCF growth rate outpacing the EBITDA growth rate.