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FCF conversion: when earnings turn into cash

Definition of FCF conversion (FCF / net income), its formula, where to find its parts in an annual report, usual thresholds, traps and the sectors where it misleads.

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Definition

FCF conversion compares free cash flow (FCF) with net income. It shows what share of accounting profit actually turns into available cash, once the capital spending the business needs has been paid. Profit that never becomes cash can neither pay down debt nor fund a dividend.

Formula

FCF conversion = (operating cash flow − purchases of property, plant, equipment and intangibles) / net income

Where to find it in an annual report

Operating cash flow and capital spending (purchases of property, plant, equipment and intangible assets) are in the cash flow statement. Net income is at the bottom of the income statement. Use net income attributable to the parent and FCF on the same scope.

Common thresholds

Long-term quality: 90% or more on average over 5 years, warning below 70%. Conversion durably above 100% is common in companies whose depreciation exceeds their capital spending, or which collect cash before delivering (subscriptions). For a fast-growing company, lower conversion can come from deliberate growth investment.

In the preset strategies

Preset strategy Criterion met To monitor Criterion not met
Long-term quality FCF / net income (5-year average) ≥ 90% 70% to 90% < 70%

Pitfalls

  • A single year says almost nothing: inventory, receivables and capital spending vary a lot from one year to the next. Look at the 5-year average.
  • High conversion can come from capital spending that is too low, setting up a costly catch-up later.
  • Stock-based pay increases operating cash flow without any cash going out: conversion looks better than the economic reality.
  • Since IFRS 16, lease payments have partly moved out of operating cash flow: some companies calculate FCF after leases, others do not. Check the definition used.

Where it does not apply

  • Banks and insurers: their cash flows mix the business with deposits or premiums, so FCF makes no sense.
  • Loss-making companies: with negative net income, the ratio can no longer be read.
  • Property development and long-cycle businesses, where cash receipts and accounting profit are several years apart.

A worked example

A fictitious company, called Company C here, generates €85 million of operating cash flow and invests €25 million in its plants and software. Its FCF is therefore €60 million. Its net income is €70 million.

Its FCF conversion is 60 / 70 = 86%. On this single year, it falls in the orange zone of the Long-term quality preset strategy. If the 5-year average is above 90%, the gap probably comes from a year of heavier investment.

FCF and net income: why they differ

Net income records sales when they are invoiced and spreads the cost of investments through depreciation. FCF counts money when it comes in and when it goes out. In a healthy company, the two converge over the long run. A gap that widens year after year calls for an explanation. See also the FCF yield entry.

Sources