How to Analyse Cash Conversion

Testing cash conversion is a procedure, not a ratio. Six steps in order: establish the basis, compute the headline ratios, bridge from profit to operating cash, separate the non-cash charges from the working capital movements, check what sits below the operating line, and write down what would settle each remaining question. Run in order, the six steps show where profit and cash parted company. No step in the sequence shows whether the answer is good.

Here is what sits underneath that. Cash conversionThe general question of how much of a reported profit actually arrived as money in the bank during the same period. Cash conversion is answered with several measures rather than one, and no measure among them is a defined line in any statement. is a question rather than a defined line, and that is the first thing to hold on to. No statement anywhere prints a figure labelled cash conversion. A set of accounts provides a profit figure and an operating cash figure, both audited, printed a few sheets apart. The exercise is finding out why the two disagree and what kind of disagreement it is.

Think about a shop on a busy street for a moment. The owner counts up the year and says she made Rs 8,00,000. Ask her for it and she opens a cash box with Rs 40,000 in it. Nobody has stolen anything. Rs 3,00,000 is sitting in stock stacked to the ceiling because she bought ahead of the school season, Rs 4,00,000 is owed by two schools that pay in ninety days, and Rs 1,00,000 went on a new counter. Every one of those is a real thing and she can point at each of them. None of them can be spent. The gap between the profit she counted and the money she can touch is the whole subject, and the six steps below are a disciplined way of walking that gap.

The feeder lines this procedure needs are already in place. Operating cash flow, investing and financing were published for Anjani Stationers Private Limited at Rs 36,30,000, minus Rs 34,00,000 and minus Rs 4,30,000, with cash moving from Rs 7,00,000 to Rs 5,00,000. The working capital cycle of 143.1 days, lengthened from 129.6 days, was established separately. Depreciation and provisions were established as charges that reduce profit without moving cash. None of that is rebuilt here. The six steps put those figures in an order and state what each position in the order is for.

In what order is the arrival of profit as cash tested?

Six steps, and the order is the content. The same business under two presentation choices reports two different operating cash figures. A reader who computes the ratio first and establishes the basis afterwards has already produced a number that may be answering a different question from the one they think. Every step after the first is interpretable only once the step before it has been done, so the value of this procedure lies entirely in the sequence.

1. Establish the basisWhose accounts, presented how, and where the interest and tax lines have been put. Nothing computed yet.
   Checking: standalone or consolidated, direct or indirect presentation, and which section carries interest.
2. Compute the headline ratios and note what each cannot seeOperating cash against profit, operating cash against the trading surplus, and free cash flow.
   Checking: how far apart are profit and cash, and where does each measure stop looking?
3. Read the bridge from profit to operating cash, term by termThe statement already prints it. The task is to confirm it reconciles and to see which term did the work.
   Checking: does the bridge tie to the rupee, and which single line dominates it?
4. Separate the two kinds of differenceNon-cash charges on one side, working capital movements on the other. Separating the two is the analytical heart of the sequence.
   Checking: how much of the gap will never reverse, and how much of it can?
5. Check what sits below the operating lineInvesting and financing. The ratios above stopped before these and cannot see them at all.
   Checking: did the cash balance rise or fall, and which section moved it?
6. Write down what would settle each remaining question, and stopQuestions with the evidence that answers them. Not a verdict.
   Checking: could somebody else take the list and go and find each item?

What has to be established before computing anything?

Step one produces no number at all and so it gets skipped. Skipping it is how a careful reader ends up with a careful answer to the wrong question. Three things have to be settled first. Whose accounts are in hand, standalone or consolidated. A business with a subsidiary reports two sets of accounts and the two sets do not agree. How the statement was presented, by the indirect methodA way of presenting operating cash flow that starts from a profit figure and adjusts it, rather than listing receipts and payments. Most published statements use the indirect method, and that is why a bridge is printed at all. that starts from a profit figure and adjusts it, or by the direct method that lists receipts and payments. And where the interest and tax lines have been put. A statement is allowed to present interest paid in the operating section or in the financing section, and the choice moves a real amount of money between two sections without changing anything at all about the business.

Moving the interest line between two sections changes reported operating cash flow without changing a single rupee of cash. The basisThe set of presentation and scope choices behind a published figure: whose accounts, prepared on what method, with which items placed in which section. Two businesses on different bases are not directly comparable. must therefore be established before any ratio is computed rather than after. Watch it happen on Anjani Stationers. Its finance cost of Rs 3,50,000 sits in the financing section, and operating cash flow is therefore Rs 36,30,000. Present the identical year with interest paid inside the operating section instead and operating cash flow reads Rs 32,80,000. Rs 3,50,000 has moved across the boundary. The conversion ratio falls from 1.21 times to 1.09 times. Not one rupee has actually moved, so the bank balance on the last day of the year is Rs 5,00,000 in both presentations.

Which ratios come first, and what can none of them see?

Step two produces three numbers and every one of them stops at the same place. Operating cash flow against profit after tax is the headline: Rs 36,30,000 over Rs 30,00,000, or 1.21 times. Operating cash flow against the trading surplus is the second: Rs 36,30,000 over earnings before interest, tax, depreciation and amortisation (EBITDA) of Rs 53,50,000, or 67.9 per cent. And free cash flowOperating cash flow less capital spend. Free cash flow measures what the year generated after keeping the asset base fed. Capital spend is what gets subtracted, never the whole investing section. is the third: operating cash flow of Rs 36,30,000 less capital spend of Rs 13,00,000, giving Rs 23,30,000, or 43.6 per cent of EBITDA. The capital spend figure is the Rs 12,00,000 of property, plant and equipment plus the Rs 1,00,000 of software, and free cash flow here means operating cash flow less that, never operating plus the whole investing section.

All three ratios stop at the operating line, so none of them can see whether the cash balance rose or fell, and a reader who treats any of them as a statement about the bank account has read a measure that was never looking there. The second ratio says something the first ratio hides, and it is the one worth pausing on. Anjani Stationers generated a trading surplus of Rs 53,50,000 and turned Rs 36,30,000 of it into cash. Nearly a third of the surplus did not arrive. The first ratio, at 1.21 times, is above one and reads as comfortable. The second, at 67.9 per cent, is the same year saying that a large amount of the trading result stayed somewhere other than the bank. Both are correct. The two ratios differ because profit after tax has already had depreciation taken out of it and the trading surplus has not.

How is the gap between profit and cash located?

Step two named a gap. Step three is where the contents of that gap come out. The statement already prints the working, so nothing has to be constructed. The bridgeThe list of adjustments a statement prints between a profit figure and operating cash flow. Reading it is a matter of checking it ties and seeing which line dominates, not of building it. is a printed list of adjustments, and this step has exactly two tasks: confirming that it reconciles to the rupee, and seeing which single term is doing most of the work. If it does not tie, a line has been misread or a figure picked up from a different column, and that has to be fixed before any of the rest means anything.

Anjani Stationers' bridge runs from a trading surplus of Rs 53,50,000 to operating cash of Rs 36,30,000 in three moves, and the Rs 17,00,000 working capital movement is more than twice the size of every other adjustment put together. The walk runs like this. The bridge starts at EBITDA of Rs 53,50,000. The Rs 6,00,000 provision reduced profit and moved no money, so it goes back in, to reach Rs 59,50,000. The Rs 17,00,000 that the working capital cycle absorbed comes out, to reach Rs 42,50,000. Rs 6,20,000 of tax actually paid comes out, and the figure lands on Rs 36,30,000 exactly. There is a fourth number worth noticing on the way past: the tax charged against profit for the year was Rs 8,00,000 while the tax paid in cash was Rs 6,20,000, a difference of Rs 1,80,000, and the tax note is where that is explained.

Which differences will reverse, and which never will?

Step four decides whether the whole exercise was worth doing, and it is the one most often skipped because the bridge in step three lists every adjustment in a single column as though every entry were the same kind of thing. Two completely different animals are sitting in that column, and once they are separated the ratio in step two starts meaning something.

A non-cash chargeA cost recorded against profit that moved no money in the period, such as depreciation or a provision. A non-cash charge is added back in a bridge because profit already carries it and cash never did. is a cost the accounts recognised that used no money this year. Anjani Stationers carries Rs 18,00,000 of them: Rs 12,00,000 of depreciation and the Rs 6,00,000 provision. Both charges are the accounts saying that something was consumed or that an obligation became probable, and neither statement required a payment. A working capital movementThe change in the money tied up in receivables, inventory and payables over a period. An increase absorbs cash; a decrease releases it. The change is a movement, not a cost. is a different creature entirely. Anjani Stationers' cycle absorbed Rs 17,00,000. The business earned that Rs 17,00,000 and it is currently sitting inside stock in the shed and inside invoices that schools and dealers have not yet paid.

Take the household version before the accounting one. A scooter loses value every year and that loss is real and permanent: nobody is going to hand the value back. Money lent to a cousin is also gone from the account this month, but it is a completely different kind of gone. The loan may come back, and the household is entitled to ask for it. Both reduce what is in the bank today. Only one of them is a cost. A non-cash charge is structural and never reverses. A working capital movement is a loan the business has made to its own trading cycle and can come back. Treating both kinds of difference as the same item is the commonest error in cash analysis.

The two consequences are opposite and both matter. The machinery will keep depreciating, so Rs 18,00,000 of non-cash charges will be there again next year in some form. Half of the gap between profit and cash is therefore a permanent feature of how this business reports rather than news. The Rs 17,00,000 in the cycle is news. The Rs 17,00,000 could come back in full if the cycle shortens and could grow if the cycle lengthens again, and it went out at all because the cycle stretched from 129.6 days to 143.1 days. One number is about the accounting. The other is about the trading.

What sits below the operating line, and why does it matter?

Here is the honest part of the procedure, and it is the reason step five exists as its own step rather than as a footnote to step two. Anjani Stationers converted at 1.21 times, the direction a reader generally wants. Its cash balance fell, from Rs 7,00,000 to Rs 5,00,000. Both of those statements are true about the same twelve months and neither of them is a mistake.

Follow the money all the way down. The year opened with Rs 7,00,000. Operating brought in Rs 36,30,000. Investing took out Rs 34,00,000, being the Rs 13,00,000 of capital spend plus Rs 21,00,000 that went into the holding in Chitra Binding Works. Financing took out Rs 4,30,000, including the Rs 3,50,000 finance cost and leaving Rs 80,000 of other financing movement. Rs 7,00,000 plus Rs 36,30,000 less Rs 34,00,000 less Rs 4,30,000 is Rs 5,00,000, and that is the balance sheet figure exactly. Everything that made the balance fall sat below the line the ratio was reading. A conversion ratio and a cash balance answer different questions and can point in opposite directions without either of them being wrong.

There is one more thing on the cash line worth carrying into step six. The Rs 5,00,000 at the year end sits alongside a cash credit facility that was drawn through the school-supply season and cleared before the year end, averaging about Rs 26,40,000 across the year. So the closing balance is a photograph taken on one particular day, and on most of the other days of that year the business was running on borrowed money. Nothing about that is hidden or unusual for a seasonal business. The closing balance simply describes the year end and not the year.

Three settings of the working capital movement are worth reading in numbers. At the published Rs 17,00,000 the ratio is 1.21 times and cash closes at Rs 5,00,000. Pull the working capital movement down to Rs 15,00,000 and operating cash flow is Rs 38,30,000, the ratio rises to 1.28 times and the cash balance ends exactly where it started, at Rs 7,00,000. Push it to Rs 23,30,000 and operating cash flow is Rs 30,00,000, the ratio is exactly 1.00 and the closing balance would be short by Rs 1,30,000. The second business on the panel reaches the identical 1.21 times on Rs 5,10,000 of gross movement against Anjani Stationers' Rs 38,50,000. The same ratio describes wildly different years.

When does the procedure stop, and what is the output?

Step six is a list, and the discipline is that every item on it is a question paired with the specific document that would answer it. Not a conclusion with a hedge attached. On Anjani Stationers the list has four items and it is short on purpose.

The output of this procedure is a set of questions with named evidence beside each one, and a reader who has produced that list has finished. Turning any of it into a verdict requires information the procedure never gathered. Notice what is not on the list. There is no line saying conversion was strong or weak. There is no comparison with any other business. There is nothing about next year. Each of those would require either a standard of adequacy the procedure has not established or a set of accounts it has not read, and inventing one at the last moment is how careful work turns into an opinion nobody can check.

What must never be a step?

Three things get added to this procedure by people who have run it properly up to that point, and each of them undoes the work. The first is judging whether the conversion is adequate. Nothing in the six steps establishes a standard of adequacy, and a business that converts at 1.21 times while deliberately building stock ahead of a season and a business that converts at 1.21 times because its customers pay on delivery are not comparable on the number. The second is reaching for an industry figure. Even leaving aside where such a figure would come from and how old it would be, the comparison assumes the businesses share a trading cycle, a seasonal pattern and a set of presentation choices, and step one exists precisely because they often do not.

The third is the most tempting and the most damaging. A conversion ratio describes a year that has already happened, and the largest single item inside Anjani Stationers' ratio is exactly the kind of thing that does not repeat, so forecasting next year's cash from this year's ratio projects the one number in the calculation that has no reason to persist. The composition settles it. The machinery keeps depreciating, so the Rs 18,00,000 of non-cash charges will recur in some form. The Rs 17,00,000 of working capital absorption is a movement, and a movement of that size in the same direction two years running would itself be the finding. Projecting the ratio forward silently assumes the cycle stretches by the same amount again.

Who runs this procedure, and what do they do with the answer?

Three different people open the same statement in the same week and stop the procedure at different steps. Where each of them stops shows which step deserves the most time.

A lender runs the procedure for step five, an analyst runs it for step four, and Vaidehi Rao as finance controller runs it for step three, and each of them is right to stop where they stop. Watch each of them work. The lender is deciding whether the seasonal facility should be renewed, so the question is whether trading throws off enough cash to service and clear a drawn facility across a season. The ratio in step two is nearly useless for that. The lender wants step five: cash went from Rs 7,00,000 to Rs 5,00,000, Rs 34,00,000 went out of the door on investing, and the facility ran at about Rs 26,40,000 on average through the year while the year-end balance shows nil. The lender is looking at the shape of the year, not the photograph at the end of it.

The analyst is doing something different and stops at step four. The question there is how much of the 1.21 times is structural and how much is a movement. Only the second part can swing next year. Rs 18,00,000 that will not reverse against Rs 17,00,000 that can is the entire answer, and it converts a single reassuring number into two numbers that behave in opposite ways. And Vaidehi Rao, sitting inside the business, has the most immediate use of the three. She reads step three, term by term. The Rs 17,00,000 in the bridge is not an abstraction to her: it is stock in a shed and invoices with school names on them, and each line in the bridge points at somebody she can telephone. The same six steps run for three different purposes, and none of the three produces a verdict on whether the year was good.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited and Vaidehi Rao are invented.
Educational material. Not advice on any investment, tax, budget or market position.