Free Cash Flow Conversion Analysis


In this tutorial, you’ll learn how to use Free Cash Flow (FCF) Conversion Analysis to determine how “reliable” a company’s EBITDA is, and how much EBITDA actually translates into cash flow from business operations; you’ll also see a few examples of how to use this analysis in valuation and leveraged buyout scenarios.

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Table of Contents:

1:33 Problems with EBITDA

4:12 FCF Conversion Calculation – Example

8:07 How to Use and Interpret FCF Conversion Analysis

13:38 Recap and Summary

What’s the Problem with EBITDA?

While EBITDA – Earnings Before Interest, Taxes, Depreciation & Amortization – is a common metric in valuations and leveraged buyout scenarios, it is not always accurate.

It’s supposed to be a proxy for a company’s Cash Flow from Operations, because just like with CFO you add back D&A and ignore CapEx. So EBITDA, theoretically, should be close to the company’s recurring cash flow generated by its core business operations.

However, EBITDA also ignores:

-Interest and taxes, both of which could be huge, and both of which ARE reflected in Cash Flow from Operations.

-The Change in Working Capital, which could also be very significant, and which is also reflected in Cash Flow from Operations.

-CapEx – Yes, Cash Flow from Operations also ignores CapEx, but that practice makes both of these metrics less reliable indicators of a company’s discretionary cash flow and ability to repay debt principal.

Solution: FCF Conversion Analysis

To tell how reliably a company turns EBITDA into real cash flow, you can compare its Free Cash Flow – defined as CFO minus CapEx – to its EBITDA, and see what percentage its FCF represents.

For example, for Foot Locker the percentages range from 30% to over 60%, indicating that the company is turning 30-60%+ of its EBITDA into Free Cash Flow each year.

In theory, the higher the FCF Conversion, the better, because it means the company is able to generate more cash flow from its business.

However, it also depends on the source of that FCF Conversion – is it driven by policies where customers pay upfront in cash before products are even delivered? If so, that’s very positive because it means the company gets more cash earlier on, on a consistent basis.

On the other hand, if it’s driven by one-time tax benefits, non-recurring items, or strange Working Capital treatment, none of those is a positive sign.

You can use FCF Conversion to compare peer companies and see which one(s) might be deserving of a higher valuation multiple.

For example, HomeAway has a much higher FCF Conversion (around 100%) than many of its peer companies such as PriceLine and TripAdvisor. So you might argue that it should be valued at a higher multiple, even if its growth rates and margins are similar to those of other companies.

You can also use FCF Conversion to develop or support your investment thesis in a leveraged buyout or growth equity candidate.

For example, we use it in our 7 Days Inn case study to show how the company’s switch to a franchised business model will make it a less capital-intensive business and improve its FCF generation capabilities.

Finally, you can use FCF Conversion to determine how much debt a company can take on, and whether that figure should exceed or be below the median figure for peer companies.

For example, if the peer companies have around 4x Debt / EBITDA but only ~50% FCF Conversion, but the company you’re analyzing has 75% FCF Conversion, perhaps it can afford to take on more debt – maybe up to 4.5x Debt / EBITDA or even 5x Debt / EBITDA.

FCF Conversion is by no means a perfect analysis, but it is a useful tool to assess a company’s ability to generate cash flow and to see how reliable credit-related stats like Debt / EBITDA and EBITDA / Interest really are.



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  1. Thanks for this great video. However, I noticed that we compare an after-tax figure (Free Cash Flow) with a before-tax figure (EBITDA). Shouldn't we take the tax out of EBITDA? How does this work?

  2. Hi Brian, what does the "FCF Yield %" mean in this case? It appears in 05:26 in the spreadsheet but you don't mention it in the video. According to Investopedia it is FCF/MarketCap. Is that it? Thanks!

  3. I was looking at a company's 10Q and was trying to figure many things out. FCF Conversion was the most mysterious to me till I saw this video. Any suggestions on how to read a 10Q/10K for a newbie? Very basic.

  4. This is such a great video. I love the usage of the case presentation to illustrate the CFO, FCF and value drivers. I hope you can do another one in more detail tying in how each value driver would affect the final conclusions drawn.

  5. Hi Team Mergers & Inquisitions / Breaking Into Wall Street, I am Arpit Dewan from INDIA thank you so much for your Videos and most importantly sharing the Spread sheets.

    What I am not been able to learn from IB Institutes, had learned from you folks.
    With Honour I am subscibing your channels and will recommend it to all the needy analysts as well.

  6. Hi Brian – since we are reducing interest from EBITDA ( in reconciliation), this essentially becomes FCFE right ? i got confused when you said FCF, does it mean FCFF or FCFE. Since you are reducing interest, then ideally looks like FCFE, but then what about the principal payments. Wont we include those as well in reconciliation ? Please help

  7. At 6:22 in video, how did you arrive at the Net Interest Expense numbers?  Those numbers aren't in the Income Statement.

  8. Thanks a lot for the video. Quick Question – in the last part of the video, we see that the DEBT/EBITDA is very low (0.6) and it's becomes lower as the yaers progress (=0.2) so in the beginging there is no problem with this figures, right? In a way that we do'nt even need to check the conversion rate. we need to be aware of it only when the DEBT/EBITDA is high and then the FCF conversion rate can compensate on that, right?


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