{"id":21225,"date":"2019-11-12T23:05:10","date_gmt":"2019-11-13T04:05:10","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/?post_type=biws_kb&#038;p=21225"},"modified":"2024-08-14T06:46:29","modified_gmt":"2024-08-14T11:46:29","slug":"free-cash-flow-conversion","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/free-cash-flow-conversion\/","title":{"rendered":"Free Cash Flow Conversion Analysis (15:04)"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">Free Cash Flow Conversion Analysis<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/free-cash-flow-conversion\/#Whats_the_Problem_with_EBITDA\">What\u2019s the Problem with EBITDA?<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/free-cash-flow-conversion\/#Solution_FCF_Conversion_Analysis\">Solution: FCF Conversion Analysis<\/a><\/li><\/ul><\/nav><\/div>\n\n<style>.enteremail__large--inline{margin:60px auto!important}<\/style>\n<h2><span class=\"ez-toc-section\" id=\"Whats_the_Problem_with_EBITDA\"><\/span>What\u2019s the Problem with EBITDA?<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>While EBITDA \u2013 Earnings Before Interest, Taxes, Depreciation &amp; Amortization \u2013 is a common metric in valuations and leveraged buyout scenarios, it is not always accurate.<\/p>\n<p>It\u2019s supposed to be a proxy for a company\u2019s Cash Flow from Operations, because just like with CFO you add back D&amp;A and ignore CapEx. So EBITDA, theoretically, should be close to the company\u2019s recurring cash flow generated by its core business operations.<\/p>\n<p>However, EBITDA also ignores:<\/p>\n<ul>\n<li>Interest and taxes, both of which could be huge, and both of which ARE reflected in Cash Flow from Operations.<\/li>\n<li>The Change in Working Capital, which could also be very significant, and which is also reflected in Cash Flow from Operations.<\/li>\n<li>CapEx \u2013 Yes, Cash Flow from Operations also ignores CapEx, but that practice makes both of these metrics less reliable indicators of a company\u2019s discretionary cash flow and ability to repay debt principal.<\/li>\n<\/ul>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<h2><span class=\"ez-toc-section\" id=\"Solution_FCF_Conversion_Analysis\"><\/span>Solution: FCF Conversion Analysis<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>To tell how reliably a company turns EBITDA into real cash flow, you can compare its Free Cash Flow \u2013 defined as CFO minus CapEx \u2013 to its EBITDA, and see what percentage its FCF represents.<\/p>\n<p>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.<\/p>\n<p>In theory, the higher the FCF Conversion, the better, because it means the company is able to generate more cash flow from its business.<\/p>\n<p>However, it also depends on the source of that FCF Conversion \u2013 is it driven by policies where customers pay upfront in cash before products are even delivered? If so, that\u2019s very positive because it means the company gets more cash earlier on, on a consistent basis.<\/p>\n<p>On the other hand, if it\u2019s driven by one-time tax benefits, non-recurring items, or strange Working Capital treatment, none of those is a positive sign.<\/p>\n<p>You can use FCF Conversion to compare peer companies and see which one(s) might be deserving of a higher valuation multiple.<\/p>\n<p>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.<\/p>\n<p>You can also use FCF Conversion to develop or support your investment thesis in a leveraged buyout or growth equity candidate.<\/p>\n<p>For example, we use it in our 7 Days Inn case study to show how the company\u2019s switch to a franchised business model will make it a less capital-intensive business and improve its FCF generation capabilities.<\/p>\n<p>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.<\/p>\n<p>For example, if the peer companies have around 4x Debt \/ EBITDA but only ~50% FCF Conversion, but the company you\u2019re analyzing has 75% FCF Conversion, perhaps it can afford to take on more debt \u2013 maybe up to 4.5x Debt \/ EBITDA or even 5x Debt \/ EBITDA.<\/p>\n<p>FCF Conversion is by no means a perfect analysis, but it is a useful tool to assess a company\u2019s ability to generate cash flow and to see how reliable credit-related stats like Debt \/ EBITDA and EBITDA \/ Interest really are.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this tutorial, you\u2019ll learn how to use Free Cash Flow (FCF) Conversion Analysis to determine how \u201creliable\u201d a company\u2019s EBITDA is, and how much EBITDA actually translates into cash flow from business operations; you\u2019ll also see a few examples of how to use this analysis in valuation and leveraged buyout scenarios.<\/p>\n","protected":false},"featured_media":21891,"template":"","class_list":["post-21225","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-financial-statement-analysis"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/21225","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/21891"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=21225"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}