FCF conversion ratio

The FCF conversion ratio measures how much of a company's earnings actually turn into free cash flow. It's usually calculated against EBITDA, though some investors calculate it against net income instead, and it answers a simple question, out of every dollar of profit the company reports, how much of it is real, spendable cash.

The formula is:

A high conversion ratio means the business turns its reported profit into cash efficiently, with relatively light capital spending needs and working capital that doesn't tie up much cash. A low conversion ratio means a large share of that profit is being consumed by things like heavy capital expenditures, growing inventory, or slow customer collections before it ever becomes cash the company can use. Asset-light businesses like software companies tend to run high conversion ratios, while capital-intensive businesses like manufacturers or telecom operators typically run lower ones simply because of how much they have to reinvest to sustain operations.

FCF conversion is one of the clearer ways to judge earnings quality, since a company that consistently reports strong profit but converts little of it to cash is often masking working capital problems or unsustainable capital spending patterns behind the headline earnings number. Comparing conversion ratios across companies in the same industry is generally more useful than comparing across industries, since the underlying capital intensity of the business sets a natural ceiling on how high the ratio can realistically run.