What is Free Cash Flow from EBITDA?
To calculate free cash flow from EBITDA, we need to understand what EBITDA is. It is the earnings of a firm before paying interest, taxes, and depreciation and amortization expenses. Thus,
Note that the earnings used for this calculation are also known as net profit after tax or the bottom line of the income statement. Let us now look at how Free Cash Flow to Equity and Free Cash Flow to Firm can be calculated from EBITDA.
Calculation of Free Cash Flows from EBITDA
When we have EBITDA, we can arrive at the free cash flows to equity by performing the following steps:
To arrive at free cash flow to the firm from EBITDA, we can perform the following steps:
The first three quantities make EBITDA change into Earnings before taxes. We add the depreciation & amortization expense to the earnings because it is a non-cash expense. The working capital that is initially fed to operations is eventually gained back, causing it to be added to the free cash flows.
Locating these items on the company’s financial statements is simple. On the income statement, you get interest expense and taxes. The capital expenditure can be traced from the cash flow statement, and so can the depreciation and amortization expense. Whereas, the changes in working capital can either be obtained from the supporting schedule of working capital or from the cash flow statement. The net borrowings, being a function of issued debt and repaid debt, can be deduced from the cash flow statement.
Examples of Free Cash Flow from EBITDA (with Excel Template)
Given below are some examples of free cash flow from EBITDA.
Example #1
Consider a tea company with $400,000 in depreciation and amortization and EBITDA of $20 million. It has $3 million in net debts and pays $200,000 as interest expense. The capital expenditure for the year is$80,000. Also, consider $400,000 to be the change in its net working capital. What are its free cash flows to equity if a tax rate of 25% is applicable?
Solution:
We should always list out the item that is required to be calculated in terms of given variables. Hence,
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- EBITDA: $20,000,000
- D&A: $400,000
- Interest: $200,000
- Tax Rate: 25%
- Changes in working capital: $400,000
- Capital expenditure: $80,000
- Net borrowings: $3,000,000
Free cash flows to equity = (EBITDA – D&A – Interest) – Taxes + D&A + Changes in working capital – Capex – Net debts
When we substitute values, we get FCFE = $12.27 million
And,
Free cash flows to firm = (EBITDA – Interest) *(1 – Tax rate) + Interest*(1 – Tax rate) – Capex + Changes in WC.
- FCFF = $15.32 million.
Notice that the free cash flows available to the common stockholders are less than those available before paying the debtors.
Example 2
Jim, an analyst in a sports apparel producing company, wants to calculate free cash flows to equity from the company’s financial statements, an excerpt of which is provided here. Also, comment on the performance of the company visible from the required calculations.
- EBITDA: $120,000,000
- D&A: $1,100,000
- Interest: $800,000
- Taxes: $34,500,000
- Changes in working capital: $65,000
- Net borrowings: $10,000,000
- Capital expenditure: $15,500,000
Solution:
In calculating free cash flows to a firm, we must start from EBITDA and subtract depreciation & amortization expense and interest to arrive at earnings before-taxes, which takes the following mathematical form.
EBITDA – depreciation & amortization – Interest expense
Further, we account for the taxes and arrive at after-tax earnings; represented by
Earnings before-taxes – taxes = After-tax earnings
In the final step, we subtract capital expenditure. Add the interest tax shield. We also add back depreciation & amortization, which is the non-cash part of financials, and changes in working capital.
Free cash flows to equity (FCFE) from the EBITDA will be –
Free cash flows to the firm (FCFF) from the EBITDA will be –
Some points to consider:
- In the calculation of free cash flows to equity from the EBITDA as the starting point is that we can ignore depreciation and amortization expense in our equation as it occurs twice canceling its effect whatsoever.
- In these calculations leading up to free cash flows, we come across an important parameter of the financial health of the company, the after-tax earnings.
- Expenses such as capital expenditure are to be carefully considered when using free cash flows. They are subtracted from EBITDA, precisely after-tax earnings if the expenditure has increased from the previous year.
- Net borrowings are the net effect of debt issued and debt repaid by a company. This must be used with proper conventions.
- Free cash flows to firms enjoy the benefits of tax shields on interest, whereas free cash flows to equity do not.
Example 3
Can you calculate the free cash flows to firm and equity from the information provided below?
- EBITDA: $100
- Interest: $5
- Tax rate: 25%
- Cahnegs in working capital: $15
- Capex: $20
There are no net borrowings in the books
Solution:
The calculation of free cash flow to the firm (FCFF) is as follows,
- FCFF = (EBITDA – Interest)*(1-T) + Interest*(1-T) + NWC – Capex
- FCFF = (100 – 5) * (1 – 0.25) + 5 * (1 – 0.25) + 15 – 20
Note: The terms in the parentheses can be solved further as
- FCFF = (100 – 5 + 5) * (1 – 0.25) + 15 – 20
- = $70
And,
The calculation of free cash flow to equity (FCFE) is as follows,
- FCFE = (EBITDA – Interest)*(1-T) +NWC – Capex
- FCFE = (100 – 5) * (1 – 0.25) + 15 – 20
- = $66.25
The formula does not account for depreciation charges as it cancels out.
The claim of debt shareholders can be on $70 of the firm’s capital in the case of liquidation or sale. Whereas, the equity shareholders have a lesser amount to claim for, $66.25.
Key Takeaways
- Free cash flows are a descriptive measure of a company’s financial health. FCFF includes an interest tax shield as opposed to FCFE.
- They recognize the underlying expenses while calculating net cash. Special consideration to outflow/inflow conventions is necessary.
- In our case of FCFF and FCFE from EBITDA, it should be noted that a comprehensive view of the enterprise is gained because EBITDA has not paid interest and non-cash charges.
- Moreover, Free cash flows have an ingrained characteristic of resembling the actual cash position because it captures non-cash charges and capital expenditures.
Recommended Articles
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