Every book I get has 95%+ FCF conversion tags all over, but they calculate it as adj. EBITDA less maintenance capex / adj. EBITDA. These businesses have 3% of revenue getting soaked up by maintenance capex (which usually works for us), but are banks just completely ignoring the working capital components? Poor market position, business model dynamics, and supply chain issues all will contribute to earnings getting eaten up. I have seen a lot of high margin businesses with little investment required in fixed assets, but then their receivables turnover and inventory purchases show basically no cash getting generated YoY.
Maybe I am just missing something, but curious on perspectives / how to handle on the buyside.
Ah, the intricacies of Free Cash Flow (FCF) calculations! You're right, it's not just about subtracting maintenance capex from adjusted EBITDA. There's more to the story.
When calculating FCF, you start with after-tax EBIT, then add back Depreciation & Amortization (D&A), subtract Capital Expenditures (Capex), and finally, adjust for changes in working capital.
Working capital is a crucial component of the FCF calculation. It's the difference between current assets (excluding cash) and current liabilities (excluding debt). If working capital increases, it means liabilities increased, or assets decreased, which could indicate the business has either lost an asset, or agreed to pay out cash at a later point in time. In both scenarios, the business loses money.
So, if a business has high margins and little investment in fixed assets, but their receivables turnover and inventory purchases show no cash generation year over year, it could be a sign of poor working capital management. This could indeed eat into earnings and affect FCF.
On the buyside, it's essential to consider all these factors when evaluating a potential investment. It's not just about the headline figures, but also about how efficiently a business is managing its resources.
Remember, the devil is in the details!
Sources: Best way to learn PE relevant finance: I've done modeling practice, but it's going over my head, How do you get from EBITDA to free cash flow?, POPULAR ACCOUNTING/FINANCE QUESTIONS, Working Capital considerations in LBO
Sellside banks are, yes. Lenders aren't.
It could also be the types of businesses you are looking at as well. This is pretty typical with services / software
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