Calculating LFCF (Do you start at EBITDA or NI?)
10xEbitda and Street of Walls do so as NI + D&A - CapEx - Changes in NWC
WSO prep has it as EBITDA - CapEx - Cash Interest - Taxes - Increase in NWC.
Since cash interest and taxes would already have been taken into account, EBITDA - CapEx - Taxes should be same as NI + D&A right? Why not just start at NI then?
Also do you typically assume that you pay back debt at exit or do you pay down each year? Does it make a difference to exit outputs depending on which option you choose? Im thinking that if you pay down each year with all the LFCF you generate for that year, the cash interest charged decreases as principal falls, but youd also have no positive streams of cash each year after doing so. Since IRR is dependent on these cash streams, youd have 0 cash flows until exit, which would drive down IRR? So better to pay back debt at end? Does that thinking make sense?
In a very simple model, those two LFCF calculations get you to the same exact place. This becomes more complicated when working off of real financial statements where there can be other below-the-line charges beyond cash interest and taxes. A real cash flow statement may include other non-cash adjustments in CFO that need to be accounted for when calculating LFCF. An example of this could be a non-cash gain/loss on a disposed asset. This impacts NI and would need to be an adjustment in your NI to LFCF walk (let's completely ignore the one-time cash proceeds from asset sale separate from the recognized gain/loss to keep it simple). You can eliminate this step (read: noise) completely with the EBITDA walk method.
In practice and day to day work, I often do the walk from EBITDA down to UFCF and LFCF rather than from NI. It's almost always a cleaner walk than the NI bridge because you can eliminate a lot of the below-the-line non-cash items of an income statement that would otherwise need to be included in the NI to LFCF walk. Separately, the relationship between UFCF and EBITDA can help validate how decent of a proxy EBITDA is for unlevered cash flow. This is the same reason why we often look at EBITDA - CapEx as a proxy for cash flow in more asset-intensive businesses. When running downside scenarios, the relationship from EBITDA to LFCF can be helpful when thinking about how bad things need to get before the company can't service its interest (the "big D not the little D" as I have heard it been called before!).
On the debt paydown, you're understanding of the concept is correct but that's not usually how it works. For a simple model, you can run it one of two ways. First, and this is more typical for a "case study" PE interview process model, cash is used for any revolver repayment and mandatory amortization on any senior debt. Any excess cash can then be deployed for additional term loan paydown. When you run it like this, your cash balance should remain at the minimum required balance through the forecast period unless all senior debt has been fully paid down. Alternatively, you deploy cash the same way for revolver and mandatory amortization, but do not do any discretionary debt paydown beyond that. In this situation, your cash balance will grow every period (assuming cash flow is positive after servicing the debt) and senior debt balance will only decrease by mandatory amortization amount per period. When you compare these two examples, the first will look slightly better than the second since the interest savings of paying down more debt outweighs the de minimis interest income you'd make on a growing cash balance. It's common practice to run initial models like the first method, because even though this doesn't reflect the reality of what might happen, a PE owner will never let an owned company just sit on a growing excess cash balance (that cash will be put to work or utilized somehow).
What you are suggesting would further juice the IRR since you're taking all the excess cash flow out the company and providing interim distributions. You're correct that returning this capital sooner and doing the bare minimum to service the debt would result in better returns. In reality, this will likely not be the case due to your agreements with a senior secured lender. You may be able to arrange flexibility such that you can take out some amount of distributions provided the company achieves certain cash flow hurdles (real example: we have a portco with a $600M+ term loan but can still take out a small dividend every quarter), but I would say a deal model's returns would never underwrite to this kind of scenario. If you have a business that has a very strong cash flow profile, you might instead run a case where you do a dividend recap after ~2-3 years to help juice IRR (but at a very minor expense to MOIC and overall profit $). Example of this would be putting 5x leverage on a company at initial close but it can get down to 3x in 2 years. At end of year 2, you assume you can re-up the leverage back to 5x (so you are getting 2 turns of purchase price off the table plus 2x of whatever EBITDA growth has occurred since acquisition).
Thanks! Dont you have to calculate EBIT and EBT in any case in order to be able to calculate the taxes (which are based on EBT)? therefore you are already at NI anyways...
Correct, taxes will impact net income (if you're doing a bottoms up approach)
Don't forget that taxes are also impacted by interest
if you haven't doneso already, check out lifeandlevfin. they have a good beginner model excel lbo case study that will help you with some of your fcf calcs.
Hi this is super helpful and detailed! I really appreciate you taking all the time to write this out and explain it so clearly. I guess when you run a paper LBO case study and assume payback of debt at end, it is just to keep things simple? Would make sense that you have to pay down on revolver and make mandatory amortizations on senior debt during holding period as lenders would have that in their covenants.
So my takeaways (and some follow-on questions) from your answer is:
Better to develop a habit of using EBITDA walk through over NI to account for other expenses after cash interest
Relationship between EBITDA to LFCF can be a helpful proxy / estimate for worst case downside scenario without defaulting on interest payment. Is little d referring to inability to pay back interest but paid back during grace period so soft default whereas big D refers to actual default and need to file for either Ch 7 or 11? Is the reasoning here that interest expenses are not accounted for in EBITDA but LFCF shows your cash profile after paying interest? So if EBITDA is low or god-forbid negative, you may likely be in trouble with servicing interest payments on debt? So you can play around with margin / growth projections to see what minimum EBITDA could be relative to LFCF?
More advantageous to pay down debt loan faster than is required vs. holding onto a stockpile of cash till exit
Interim distributions will boost IRR, but paying out dividends over holding period is typically not built into the models. Instead for those companies that generate a healthy, consistent stream of cashflow, build a divident recap during holding period scenario
You're correct regarding the paper LBO. For those, keep it simple and assume no debt paydown during the hold period (i.e., same interest payment every year). Forget amount mandatory amortization and the revolver should not come into play at all assuming it's a cash flow positive business. Side note from personal experience, I only had to do one of these back when I was recruiting for associate roles years ago and it was a very straightforward simple one. I've never asked it to potential candidates in interviews (sitting on other side of the table) as I find they are very easy to prep for and not intellectually stimulating/good interview questions.
On the default question. That's just a silly phrase I've heard thrown around at work - I included it to lighten the mood of my post (humor being in the double meaning!). "Little d" would be something like busting a covenant. EBITDA drops such that you're in breach of covenant but the company is still solvent and cash flows enough to service it's debt. These situations can be resolved with equity cures. One of the ways we mitigate this is by building in an EBITDA cushion when working with lenders during a deal. For instance, we usually include a credit stats sheet in a model and will ask for 30-35% EBITDA cushion on a proposed covenant test (i.e., EBITDA would need be 30-35% worse than proposed plan for a covenant bust to occur). "Big D" occurs when LFCF goes negative and you no longer have enough cash flow to even pay the interest expense (let alone mandatory amortization). This is a very extreme way to look at things, since there will obviously be major warning signs (e.g., covenant bust, liquidity issues) that occur before falling to a point where you can't even service your interest payments.
Heres a better question:
EBITDA - CapEx - Cash Interest - Cash Taxes - Increase in NWC almost never matches CFO-capex perfectly. There's always an inability to proper calculate true cash EBITDA (Which NI + D&A + the various one time CFO addbacks + cash int + cash taxes should equal to) as well as somewhat complex accounting of calc'ing cash taxes (is it income tax expense on IS + Deferred tax CFO line item + some of the movements changes in tax working capital accounts which never foots to supplementary cash taxes paid cash on FCF statement).
Now, sometimes the difference between CFO-capex and the typical ebitda walk are within a few million but sometimes can be off by 5-20%. how do you reconcile this as a PE/HF analyst? Do you add a line item "other" that just plugs for the cfo-capex differential so it foots, or do you keep pounding at trying to reconcile which exact bucket of ebitda/cashing/cashtax/workingcap should be adjusted?
So a few things here that may answer some of the other follow-up questions above that I may have left hanging.
Firstly, when I talk about an EBITDA to LFCF walk, it's exactly that: a walk. That does not mean I am using just that EBITDA line to calculate everything else in the walk. I have a full model where I have separately calculated cash taxes correctly (which accounts for things like D&A shield) and pulling those calculated amounts in. The walk is simply for presentation purposes - it's leveraging a fully built model (income statement, cash flow, etc.). As a check, you should be able to walk to the same LFCF numbers from your calculated NI.
Separately, you can do quicker versions of these calculations if you're building a simple "cash flow" model. In situations like this, obviously make sure you are factoring in the D&A and interest shield for your cash tax calculations. These are for quick exercises that can let you see if numbers make sense on something in a very short amount of time. They're not perfect; the benefit of them is the ability to get to a rough answer quickly using reasonable assumptions.
In response to your direct question, it sounds like some of the issue is likely in below-the-line items captured in NI and other amounts present in CFO. Common one you see in sponsor models is management fees. EBITDA is presented without the impact of management fees but that amount does impact your NI and cash flow. It's already in your NI and it's real cash, so you wouldn't see it as a line-item in CFO unless it was an accrued expense not yet paid (then it's an add back to cash in CFO). Other similar examples to this (not sponsor related) could be things like non-recurring charges and FX gains/losses -- all below-the-line items.
You are correct that cash taxes can be tricky. Depends a lot on the company and how complicated their tax structure is. This can also be a real pain when looking at historical financials and doing this using SEC reporting docs like 10-Ks and Qs. If bridging from EBITDA, I tend to focus on the CFS and supporting notes on taxes. Tax-related items can show up in both places in CFO (up top in adjustments to NI and separately down in working capital balance sheet line-items). One easy tip here is to make sure you're not double counting anything (i.e., change in NWC and taxes where your NWC amounts have some of those tax accounts already baked in).
Not sure how much this helps answering your question. Feel free to PM me if you want to walk through a specific example.
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