What is cash conversion efficiency?

Cash conversion efficiency measures how effectively a company converts profit into operating cash flow, typically calculated as operating cash flow divided by net income. For professional service firms, this metric reveals whether reported profits translate to actual cash. A ratio below 1.0 indicates profit is not fully converting to cash, often due to working capital growth or timing differences.

Key characteristics

• Compares operating cash flow to net income

• Ratio above 1.0 indicates strong cash generation

• A ratio below 1.0 indicates cash consumption

• Affected by working capital changes

• Should be tracked over time for trends

• Reveals the quality of earnings from a cash perspective

Why it matters for professional service firms

Profitable firms can face cash problems if profits do not convert to cash. A growing firm with 0.7 cash conversion efficiency generates only $0.70 in cash for every $1.00 of profit, with the rest consumed by working capital growth. Understanding cash conversion helps explain why profitable growth can feel cash-constrained. Professional service firms should track cash conversion and take action when efficiency falls significantly below 1.0.

Real-world example

David's firm reported $320K in net income, but cash grew by only $180K, resulting in a 0.56 cash conversion efficiency. Analysis: AR grew $95K (clients paying slower), prepaid expenses increased $25K (annual payments made), and WIP increased $35K (billing delays). The profit was real, but it was consumed by working capital growth. Actions: collection improvement reduced AR growth, shifted some annual payments to monthly, and improved billing speed. Next year: $340K net income converted to $295K cash (0.87 efficiency). Understanding the dynamic enabled targeted improvements.