Hi After a series of PE interviews, I keep getting stuck on questions about what drives cash flows, how I come up with assumptions, which is an area that I haven't seen in most of the interview guides. This then makes it hard to justify what an investment is good or not. Confession: my deal experience in banking has not been great so I wanted to brush up on this topic. Any advice from current or future PE candidates?
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I could be off base but I would think P&L and Working Capital components
P&L: Revenue (price & quantity) COGS (Gross margin) SG&A
Working Capital components: AR AP Inventory Deferred Revenue
The components of cash flow include:
EBITDA (P&L items as mentioned above) Taxes (cash taxes) Interest (cash interest for levered companies) Working Capital (balance sheet items as mentioned above) Capex (cash flow item)
These components drive cash flow, and depending on the company and industry, there are many factors that a PE investor will look at in evaluating companies.
EBITDA is the sales and operating expenses that drive the business. Providing a good or service generates sales, and incurring expenses to provide that good or service is deducted from sales to evaluate profitability (note that profitability does not necessarily equal cash flow because of the items below). So a high priced, low cost good or service will generate high EBITDA margins, which gives you more to play with when determining cash flow.
Interest and taxes are costs of doing business for the government and your lender. Taxes are taxes, but interest is highly dependent on whether you've got debt or not.
Working capital is important to understand - when you're actually in a business, working capital is a huge driver of cash flow due to the timing mismatches between when products and services are provided to customers and from suppliers and when each get paid. An increase in current assets is a use of cash (because you're providing the good or service now, but aren't getting paid for it yet) and an increase in current liabilities is a source of cash (because you're provided the good or service now, but aren't paying for it yet). Given the incentives involved with working capital as it relates to cash flow for almost every business out there, there's tension between you as a good or service provider getting paid from your customers (who have you on the books as a payable) and you as a good or service consumer paying your suppliers (who have you on the books as a receivable).
Capex is the equipment / intangible acquisition items that generate the sales. Example: a piece of manufacturing equipment that a company purchases that will manufacture widgets, which drives sales. Often bucketed into growth (ex. acquisitions of equipment) or maintenance (part of the equipment that needs to be replaced every few years and is capitalized vs. expensed). High capex businesses are large consumers of cash, which lowers your ability to pay down debt / reinvest in the business.
Long and disorganized answer, but those are the primary drivers of cash flow. Note that the above is levered cash flow. The importance of cash flow will drive decision making as it relates to debt paydown (interest and principal) and cash reinvestment into the business (capex or operating expense for growth).
My suggestion is to develop 13 week cash flow forecasts on businesses in excel. That's how I learned, just make up scenarios, play with them and get in your reps. Then think through how your CF activity ties back to BS and IS. Cashflow is the most basic financial/economic concept there is and every street merchant in the world understands it better than classically trained and degreed finance and accounting professionals. But once you 'get it' it opens the world to you in deal structuring.
Enjoy
Thanks everyone. Can people from different industries chip in with the drivers for their industries' valuation?
I think that's what they're often testing in interviews.
For natural resources, I often said commodity price for revenues.
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