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The cash conversion ratio is a type of financial management tool that helps company owners understand if the amount of revenue generated by the production process is sufficient, given the expenses associated with that process. A basic formula for arriving at the ratio involves identifying the total cash flow that results from the operations effort and relating that flow of cash from sales to the expenses that are incurred at part of the manufacture of the goods that led to those sales. The expectation is that the company does generate enough revenue to offset all net expenses and still have enough left to handle obligations like taxes and post a net profit for the business.
In order to determine the cash conversion ratio, the first step is to identify the cash flow generated from sales during a specified period of time. Once that figure is verified, totaling the costs of production is necessary. This includes expenses such as the costs of maintaining the plant facility and operating the equipment used in the manufacturing process. These costs are deducted from the cash flow, leaving a figure that is then divided by the amount of earnings before interest tax and amortization, also known as EBITA.
One of the benefits of calculating the cash conversion ratio is that business owners can determine how much of the net profits remain after all obligations are met. Ideally, the ratio will indicate that the business is operating at a sufficient level of profit to justify continuing the operation, and possibly enough to aid in gradually expanding the business. When the cash conversion ratio is somewhat low, this is an indication that some changes are necessary in order to continue the operation, often by eliminating waste in the production process while also seeking to engage in activities designed to capture a greater market share and increase sales.
The process of determining a cash conversion ratio is also important for investors who are thinking of securing an interest in a given business operation. If the information regarding cash flow seems out of line with the sales showing on the accounting books, this can be a sign that some sort of creative accounting is taking place. With that in mind, if the ratio indicates irregularities that are difficult to justify, the investor should move on from the deal and seek an opportunity that is backed by data that is not contradictory in nature.
That is good advice, Certlerant.
If investors start calling accounting irregularities into question, a company may want to do an internal audit.
This way, they can pinpoint problems and, hopefully, either eliminate or minimize the risk of outside investigations from the Securities and Exchange Commission or Internal Revenue Service.
Any time creative accounting, as the article calls it, appears to be in play, that should automatically raise a red flag for potential investors.
At the very least, investors should ask questions of management to get to the bottom line of the accounting discrepancies.
If an investor is not satisfied with the answers he or she receives, their best bet is probably to walk away from that investment.
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