The upcoming profit reporting season will keep investors on the edge of their seats and you shouldn't forget to scrutinise one often overlooked detail in the results.
This is the cash conversion ratio, which most investors either do not know about or brush aside for earnings multiples and growth figures.
Don't get me wrong, price-earnings (P/E) ratios and sales and earnings growth are still important details this time round, as they are for every reporting season.
Cash ratio as important as profit ratio
But the cash conversion ratio (CCR) is particularly relevant in this COVID-19-stricken market. You'll see why after I explain what this ratio is.
The CCR measures the amount of cash a company collects as a percentage of earnings. Just because an ASX stock reports a $100 profit, it doesn't mean it receives $100 in cash.
Calculating the CCR is easy although few companies will do it for you when highlighting their profit and sales performance for the year.
How to calculate the cash conversion ratio
To get the ratio, you take the net operating cash flow (from the cash flow statement) and divide that by the reported earnings before interest, tax, depreciation and amortisation (EBITDA).
Don't get confused by the cash flow statement as it is broken into three sections – operations, investing and financing. Cash flow from operations reflects the cash a company gets from its ordinary business and what it pays to provide the service or products, and that's the net figure you want.
Some calculate the CCR by dividing the cash flow with net profits instead. I prefer to use the EBITDA number as amortisation and depreciation charges do not impact on cash and it produces a "cleaner" ratio.
Why cash doesn't match profit
In the vast majority of cases, you will find that the net cash from operations falls short of EBITDA. This shortfall can be significant too and will vary from sector to sector.
The general rule of thumb is that a company with a CCR of 80% or better is good. If the ratio falls below this, you should investigate why as it could be an early indication of a problem.
So why does a company's reported EBITDA not match the cash it receives? There are a few reasons for this. It could be a timing issue where a company recognises the profit from a sale before it gets paid by the customer.
Another common reason is an expansion in the company's working capital, perhaps to fund a build-up in inventory.
Early warning sign
That could be a bullish sign if management is expecting a big ramp up in near-term sales or is gearing up for the start of a big project.
But in this coronavirus recessionary environment, a material increase in working capital could be a warning sign instead as most businesses will be experiencing declining sales.
Further, many ASX companies are probably feeling a cash crunch from the COVID-19 fallout. Booking decent profits isn't enough to stave-off a capital raising if the cash isn't coming in fast enough.
Final thoughts
As I've written last week, capital raisings are one of the key features I am expecting during the reporting season. Paying attention to the CCR could provide an early clue of a company in need of fresh capital.
As a final thought, the CCR is more relevant to S&P/ASX 200 Index (Index:^AXJO) companies than small caps.
Market minnows often don't have earnings and are still making losses. You can't use the ratio if the EBIDTA number is negative.
