Free Cash Flow Conversion
Profit is an accounting result. Free cash flow is what remains in the bank after running and maintaining the business. Conversion compares the two.
Why this matters for beginners
Persistent profit without cash is one of the most reliable warning signs in company analysis. Cash is what pays dividends, debt and reinvestment.
Main explanation
Free cash flow is operating cash flow minus capital expenditure. Conversion compares free cash flow with reported net profit over the same period.
Conversion consistently near or above one hundred percent suggests profit is real and capital needs are modest. Persistently low conversion needs an explanation.
Common explanations are growth in receivables or inventory, heavy investment in new capacity, or aggressive revenue recognition.
Judge conversion over several years. A single weak year during expansion is normal; a five-year pattern of profit without cash is a different matter.
Example using a real company
Net profit of 100 with operating cash flow of 130 and capital expenditure of 40 gives free cash flow of 90, or ninety percent conversion.
- →Profit 100, free cash flow 90: healthy conversion.
- →Profit 100, free cash flow 20 for four consecutive years: investigate receivables, inventory and capital spending.
Common beginner mistakes
- ✕Judging conversion from a single year.
- ✕Ignoring rising receivables while revenue grows.
- ✕Treating capital expenditure as optional.
Key terms
- Free cash flow
- Operating cash flow minus capital expenditure.
- Receivables
- Money owed by customers for sales already recorded.
- Conversion
- Free cash flow expressed against reported profit.
Key takeaways
- 01Conversion tests whether profit becomes cash.
- 02Persistent low conversion needs an explanation.
- 03Assess the pattern over several years.
Check yourself
- 01Free cash flow is operating cash flow minus capital expenditure.
- 02Profit and free cash flow are always similar.
- 03Rising receivables can reduce cash conversion while profit still grows.
Try the concept on a real company
Study a capital-intensive company in the Analyzer and compare its reported profit with the cash it generates after investment.
Educational examples only. Not buy or sell recommendations.