Which P&L, CFS, BS Items important LBO??

Thank you for indulging me in that little exercise. So there have been a few similar threads on this subject which I think got summarized at some point here: https://www.wallstreetoasis.com/forums/which-financial-statement-is-mos…

So I'll open by saying that I think this is a bit of a terrible question to ask someone in an interview without offering up a ton of additional information or clarifying exactly what you're looking for. The characteristics that make a company a good LBO candidate cannot be found on the financial statements. I'll explain later in this post.

I assume the question that the interviewer is actually trying to ask is something along the lines of: "Which metrics from the statements would you need to determine how much debt a company could support in an LBO?" In this scenario, your response is a good one. You're essentially trying to determine how much free cash flow the company generates. Here is how I would go about addressing this particular question, inclusive of explanation:

EBITDA - This is the starting point for the free cash calculation, but it is independent of capital structure. As the capital structure would change under our own ownership, it is important to identify the base earnings so we can layer in our own assumptions on debt, which drives interest and taxes.

CapEx - Pretty straightforward. CapEx can be one of the most significant uses of cash that is not necessarily captured by the income statement. Knowing maintenance versus growth CapEx is important for determining how banks will evaluate risk. Low maintenance CapEx relative to growth CapEx suggests that the company could reduce its CapEx spend during recessions or slower years in order to preserve cash flow and service debt levels. This dynamic will help the bank get comfortable providing greater amounts of debt.

NWC - Depending on the business model, I'd actually want to see each the meaningful individual components of NWC, such as Inventory, AR/AP, Accrued Expenses, etc. The idea is to calculate NWC as a % of revenue to determine the expected NWC requirements in order to grow revenue. Just knowing the change in NWC in any given year will not be valuable unless you're looking at other trending data points. For example, if a company doubles its revenue in a year, it is likely to see a huge change in NWC resulting in a big "use of cash" .. .but only in that year. The company could remain the same exact size the next year and have no change in NWC whatsoever.

In our example, you stated that a company that had a change in NWC of $75M was less attractive than one with a change in NWC of $10. I think the context is super important in this case. You cannot reach a conclusion about the quality of the company with the change in NWC unless you also overlay the corresponding revenue and earnings growth.

Also, if you wanted to get super detailed, you could also throw in things such as "tax deductible goodwill" ... but I believe this would be beyond the scope of the question.

Revisiting my original point that this isn't a good question:

The concept behind an LBO is that you use leverage to magnify your return on investment. Technically, a good LBO candidate is one that can support a significant amount of leverage relative to the value of the company as a whole. Put differently, a company that can support a high debt/equity ratio with limited amount of risk. A company valued at 5.0x EBITDA that can reliably support debt up to 4.0x EBITDA is a way better LBO candidate than a company valued at 10.0x that can reliably support debt up to 5.0x EBITDA. In the former case, you're able to achieve an a 4:1 ratio of debt:equity and in the later it's only a 1:1 ratio. You get far more leverage on your equity in the former. Note that this is very different from "What makes a good investment?"

So lots of companies could be good LBO candidates, even if they only convert a low percentage of EBITDA into free cash flow conversion. That's why you can have very successful LBOs of all types of businesses, including those with high CapEx. It's why private equity firms also look at enterprise value / free cash flow.

There is a lot more to it than this ... but hopefully this provides a good overview.