Cash conversion

Making profits is one thing – but you want to know how well a company converts these profits into cash.

A good company must make profits its income must be higher than its costs. However, profits can be manipulated with clever accounting and may not reflect the underlying reality. Savvy investors will look at a company's ability to generate hard cash, as this is what actually pays their dividends. Companies that aren't good at generating cash can be bad investments and can go bust.

So making profits is one thing but you want to know how well a company converts these profits into cash. You can do this by comparing the operating profit number from a company's income statement with the operating cash flow number from its cash flow statement.

So if a company has operating profits of £100m and operatingcash flow of £80m, it has a cash conversion ratio of 80%.You can also compare a company's net profit (the profit forshareholders) with its free cash flow (the amount of cash leftover after all costs have been paid and investments made).

There can be good reasons for cash flow falling short of profitsfor a short period of time, but big differences that happenfrequently may be a warning sign one that you shouldnot ignore.

Recommended

Margin call
Glossary

Margin call

When an investor borrows to bet on markets, they put down a deposit known as “margin”.
2 Apr 2021
Resource curse
Glossary

Resource curse

The term “resource curse” refers to the observation that countries with abundant natural resources also tend to be less economically developed than th…
14 Jan 2021
Balance of payments
Glossary

Balance of payments

The balance of payments refers to the accounts that sum up a country's financial position relative to other countries.
8 Jan 2021
Yield-curve control
Glossary

Yield-curve control

Yield-curve control is when a central bank aims to control long-term interest rates by pledging to buy (or sell) as many long-term bonds as needed to …
25 Dec 2020

Most Popular

The bitcoin bubble will burst: here’s how to play it
Bitcoin

The bitcoin bubble will burst: here’s how to play it

The cryptocurrency’s price has soared far beyond its fundamentals, says Matthew Partridge. Here, he looks at how to short bitcoin.
12 Apr 2021
Central banks are rushing to build digital currencies. What are they, and what do they mean for you?
Bitcoin

Central banks are rushing to build digital currencies. What are they, and what do they mean for you?

As bitcoin continues to soar in value, many of the world’s central banks are looking to emulate it by issuing their own digital currencies. But centra…
8 Apr 2021
Four investment trusts for income investors to buy now
Investment trusts

Four investment trusts for income investors to buy now

Some high-yielding listed lending funds have come through the crisis with flying colours. David Stevenson picks four of the best.
12 Apr 2021