FCF Conversion

Profit is an opinion. Cash is a fact. FCF conversion tells you how much of the opinion turns into fact.

The formula

FCF Conversion = Free cash flow ÷ EBITDA (or Net income)

The numerator is operating cash flow minus capital expenditure. The denominator varies — some use EBITDA, others use net income, others use adjusted earnings. The question is the same: what percentage of reported profit actually shows up as cash?

What it measures

FCF conversion measures cash quality. A business might report £10m EBITDA, but if only £6m converts to free cash flow, the real economic profit is 40% lower than the headline.

High conversion (above 80%) means reported earnings reliably turn into cash you can distribute, reinvest, or use to pay down debt. Low conversion (below 60%) means something is consuming the profit before it reaches the bank account.

The metric matters because cash pays dividends, funds acquisitions, and services debt. EBITDA does none of these things. A business with strong EBITDA and weak conversion is less valuable than the earnings suggest.

What causes low conversion

Several factors drive the gap between EBITDA and free cash flow:

Working capital growth. A growing business ties up cash in receivables and inventory. Revenue increases, EBITDA increases, but the cash is stuck in the balance sheet. This is normal for growth but still consumes cash.

Capital expenditure. EBITDA ignores the cost of maintaining and expanding fixed assets. A capital-intensive business might convert only 50% of EBITDA to FCF simply because the machinery demands constant investment.

One-off items. Restructuring costs, litigation settlements, and acquisition expenses reduce cash without appearing in EBITDA. A business with frequent “one-offs” has structurally lower conversion than reported earnings suggest.

Cash taxes versus book taxes. Deferred tax timing can create gaps between the tax charge in the P&L and the tax actually paid. Accelerated depreciation might reduce cash taxes today but reverse later.

What it hides

FCF conversion can be artificially inflated or depressed by timing.

Delaying payables. A company can boost cash flow by stretching supplier payments. Conversion looks strong this quarter; next quarter the bills come due. Sustainable conversion requires consistent working capital management, not one-off stretches.

Pulling forward receivables. Offering discounts for early payment or factoring receivables generates cash today at the cost of future cash. Conversion improves but economics worsen.

Capex timing. Capital expenditure is lumpy. A business might show 90% conversion one year and 50% the next simply because of when projects land. Multi-year averages are more reliable than single-year snapshots.

Growth distortion. High-growth businesses naturally have lower conversion because working capital grows with revenue. Low conversion might indicate a problem or simply reflect success. The metric doesn’t distinguish.

Where it breaks down

Acquisition-heavy businesses. If a company grows through M&A, cash spent on acquisitions doesn’t appear in operating cash flow — it’s in investing activities. Conversion looks strong while cash is deployed elsewhere. You need to look at total cash deployment, not just FCF conversion.

Negative working capital models. Subscription businesses collecting annual payments upfront show inflated conversion. Cash arrives before revenue is recognised. This isn’t sustainable at steady state — it only works while the business is growing.

Leases and financing. Under IFRS 16, lease payments appear partly in operating cash flow and partly in financing. A company with significant leases will show higher conversion than one that owns its assets, even if the economic reality is similar.

Definition variance. FCF can mean operating cash flow minus capex, or minus maintenance capex only, or minus all investing activity. The denominator might be EBITDA, adjusted EBITDA, or net income. Without consistent definitions, cross-company comparison is unreliable.

The decision it enables

FCF conversion tells you whether earnings are real.

High and stable conversion (above 80% consistently) suggests the business generates cash from its operations without friction. Reported profits are trustworthy for valuation purposes.

Low or volatile conversion requires investigation. Is it growth-driven working capital (temporary) or structural capital intensity (permanent)? Is it genuine investment or accounting games?

For PE investors, conversion is the bridge between EBITDA multiples and actual returns. You pay based on EBITDA; you get paid based on cash. A business trading at 10x EBITDA with 50% conversion is effectively trading at 20x free cash flow. The conversion rate changes what you’re actually buying.

The metric series: Part of a series on metrics that reveal what headline numbers hide.