EBITDA to FCF: Interview Question and Modeling Test Walkthrough

EBITDA to FCF Definition: FCF = EBITDA – Net Interest Expense – Taxes +/- Other Non-Cash Adjustments +/- Change in Working Capital – CapEx; also, always clarify which type of Free Cash Flow you’re calculating since the formula changes for other FCF variations.

This definition assumes the “standard” Free Cash Flow that is used in LBO models and financial statement analysis, but there are other variations (see below).

In investment banking interviews, it’s common to get questions about different ways to calculate metrics such as Free Cash Flow.

Unfortunately, many of the online tutorials for this topic skip the subtleties in the calculation and gloss over issues like lease accounting.

Outside of pure interview questions, this “EBITDA to FCF” question matters because, in many case studies and modeling tests, you will get a template or existing model and be asked to calculate other metrics based on EBITDA.

You must understand the type of Free Cash Flow you are calculating and the items it should deduct – if you know that, you’ll be able to calculate it starting with any metric.

We cover a few examples, variations, subtleties, and lease accounting issues below:

Files & Resources:

• EBITDA to FCF – Slides (PDF)
• EBITDA to FCF – Excel Demonstration (XL)

Video Table of Contents:

• 0:00: Introduction
• 4:21: Part 1: Alternate Ways to Calculate FCF
• 7:32: Part 2: EBITDA to FCFE and FCFF
• 9:37: Part 3: Subtleties in the Calculations
• 12:06: Part 4: Lease Accounting (Your Favorite Topic)
• 14:14: Recap and Summary

EBITDA to FCF Definitions: What is Free Cash Flow?

Free Cash Flow is normally defined as Cash Flow from Operations – Capital Expenditures, assuming that Cash Flow from Operations deducts the Net Interest Expense, Taxes, and the full Lease Expense.

(If it does not fully deduct all of these, you must adjust it.)

FCF tells you how much Debt principal the company could repay or how much it could spend on activities such as acquisitions, dividends, or stock repurchases.

In LBO models and credit models, it partially determines the “optional repayments” the company can make on its Debt balance (i.e., the cash flow sweep).

You could also calculate Free Cash Flow by starting with Net Income:

FCF = Net Income (to Common) + D&A +/- Other Non-Cash Adjustments +/- Change in Working Capital – CapEx.

Here’s an example calculation for BMC Stock Holdings, a building materials company:

It’s the same basic idea as Cash Flow from Operations minus CapEx because the first 3 terms in this formula represent Cash Flow from Operations:

To move from EBITDA to FCF, factor in all the items that affect FCF but not EBITDA:

FCF = EBITDA – Net Interest Expense – Taxes +/- Other Non-Cash Adjustments +/- Change in Working Capital – CapEx.

The tricky part is that you can’t just multiply EBITDA by the Tax Rate to calculate the Taxes.

Instead, you should deduct the D&A and Interest Expense from EBITDA to calculate Pre-Tax Income and then multiply that by the Tax Rate because these items are tax-deductible.

In other words, “Taxes” in this calculation equal (EBITDA – D&A – Net Interest) * Tax Rate:

The “Other Non-Cash Adjustments” term might also have additional adjustments for Deferred Taxes, as FCF should always reflect a company’s Cash Taxes.

From EBITDA to FCF… of Different Types

There are also different types of Free Cash Flow: Unlevered Free Cash Flow, also known as Free Cash Flow to Firm, and Levered Free Cash Flow, also known as Free Cash Flow to Equity.

In most cases, it’s pointless to walk through these bridges because these metrics are typically used for valuation purposes, such as in a DCF model, and you rarely build an entire DCF starting from EBITDA.

For completeness, however, we’ll walk through both bridges below.

EBITDA to FCFE is easier because FCFE is close to normal FCF: Take FCF, add Debt Issuances, and subtract Debt Repayments.

FCFE = EBITDA – Net Interest Expense – Taxes +/- Other Non-Cash Adjustments +/- Change in Working Capital – CapEx + Debt Issuances – Debt Repayments

EBITDA to FCFF is shorter but requires more explanation:

FCFF = EBITDA – Taxes Excluding Impact of Interest +/- Other Non-Cash Adjustments +/- Change in Working Capital – CapEx

“Taxes Excluding Impact of Interest” means what it sounds like: Deduct D&A, but not Net Interest Expense, to calculate Taxes.

FCFF or Unlevered Free Cash Flow is capital structure-neutral, so the company should pay the same amount of Taxes regardless of its Debt:

FCFF = EBITDA – EBIT * Tax Rate +/- Other Non-Cash Adjustments +/- Change in Working Capital – CapEx

Here are the calculations for BMC Stock Holdings, a building materials company used as an example in our courses:

Subtleties in the EBITDA to FCF Calculation

The examples above represent the basic calculations and simple responses that work in interviews, but real life is more complicated.

Note that “real life” includes 3-statement modeling and LBO modeling tests!

We’ll approach this section by explaining how the main deductions and adjustments in the calculation can be more complex in real life:

FCF = EBITDA – Net Interest Expense – Taxes +/- Other Non-Cash Adjustments +/- Change in Working Capital – CapEx

First, if the company has Preferred Stock, you must also deduct the Preferred Dividends along with the Net Interest since they’re also a financing cost:

Similarly, anything like “Other Income” or “Other Expenses” above the Pre-Tax Income line should be factored in because FCF should capture everything that affects the after-tax profits.

We use this approach in the BMC model, even though “Other Income” is small.

Second, Taxes can be tricky because you should technically subtract the company’s Cash Taxes.

So, if the company is using accelerated Depreciation or has items such as Stock-Based Compensation that are not tax-deductible in the current period, you should adjust the Tax number or include the effects in the “Other Non-Cash Adjustments” section, as we do in the BMC model.

Third, the “Change in Working Capital” sometimes includes more than just the explicit line items in that section.

For example, consider this Netflix financial model:

For a firm like Netflix, these “Content Assets” and “Content Liabilities” are “Changes in Working Capital” because they represent content spending.

Netflix must purchase and develop streaming content if it wants to grow, so changes in these items are a core part of its business.

Therefore, if you calculate FCF starting with EBITDA, you should definitely include these.

Finally, with the CapEx deduction, in some cases, you should also deduct items such as Intangible Purchases and Acquisitions… if they are truly recurring and core to the business.

For example, if you’re modeling a pharmaceutical company that constantly needs to acquire new drugs to remain competitive, you could easily justify a deduction for recurring Intangible Purchases.

But it would be more difficult to justify for a restaurant or retail company.

Lease Accounting in the EBITDA to FCF Calculation

One final wrinkle is the issue of lease accounting and how the rules changed when IFRS 16 and ASC 842 were implemented in 2019.

To simplify things, we recommend always deducting the full Lease Expense from both Operating and Finance Leases in FCF, no matter how it appears on the financial statements.

That translates into the following:

• Under U.S. GAAP, the Operating Lease Expense is already deducted on the Income Statement and reduces EBITDA, so you don’t need to do anything else. However, if the company has Finance Leases, you should deduct the Finance Lease Interest and Principal Repayments, which you may need to search for in the filings. If these items are small, this point makes a tiny difference and can be ignored.
• Under IFRS, you should deduct the Total Lease Interest and Total Lease Principal Repayments when moving from EBITDA to FCF. The Lease Interest is usually within the Net Interest Expense on the Income Statement, but if it’s not, you will need to create a separate line for it. To get the Lease Principal Repayments, you must look under Cash Flow from Financing on the Cash Flow Statement.

In addition, there may also be a small “net cash effect” from the Lease Assets and Liabilities changing by slightly different amounts each year; you can include this as another adjustment with the Lease Principal Repayment deduction.

Here’s an example of the EBITDA to FCF calculation for Watches of Switzerland in our Private Equity Modeling course:

Under IFRS, EBITDA excludes the entire Lease Expense, so we need to deduct the Lease Interest (included within “Net Interest Expense” here) and the Lease Principal Repayments (in the “IFRS 16 Lease Adjustments” line) to get a proper number.

You can also get the same effect by adjusting Depreciation to remove the Lease Depreciation portion, but it’s faster and easier to deduct the Lease Principal Repayment line since it’s always shown explicitly on the Cash Flow Statement.