Free Cash Flow (FCF) formula : EBITDA, EBIT, Net Income and Depreciation Tax Savings…always start with EBITDA

Readers,

Once in a while, I got a simple question whether in the Free-Cash-Flow (FCF) formula, we need to start with EBITDA or EBIT.

Well, I could say, both will give us the same results. Before we put more details, FCF formula is a concept built under no-debt world, it means there is no debt being used to finance the execution of the entity’s strategy to generate cash flows and profits (returns to shareholders). Under financial terms, it is an unlevered concept.

Additionally, as Free Cash Flow is a cash flow concept, then all components related to non-cash flow, such as depreciation, amortization, provision for bad debt, etc. in the Income Statements, need to be removed out as well. Here we will only consider the depreciation and amortization expenses as illustration.

As many financial analysts love EBITDA, then we could say in most cases, we see EBITDA comes first, and it should. EBIT comes from EBITDA, so it means the door to EBIT is EBITDA. Let me show it for you.

If we start with EBITDA, then the only component is not there is tax that is payable to tax authority.

Then, the formula will be:

Free Cash Flow = EBITDA  – EBIT*Tax(%) – Capex – change in NWC………………….(1)

Bear in mind, that EBIT*Tax(%) is the approximation of the tax expense, as there is a difference between tax and accounting in calculating the depreciation. Companies, in practice, will keep two listing in computing the depreciation expense, one in accordance with the Accounting standards, and the other following Tax rule. This has a consequence, that the tax expense calculation using EBIT*Tax(%) will not be the same with the actual tax expense that ultimately the company has to pay to the tax authority.

Or, if the financial analyst wants to show the size of the depreciation tax shield, that is the tax savings that results from the ability of the Company to deduct depreciation, thus, lowering the Company’s tax expense incurred to the tax authority, which depreciation has positive impact to the FCF, we could show the FCF as follows:

Free Cash Flow = EBITDA (1- Tax(%)) + Depreciation*Tax(%) – Capex – change in NWC….(2)

Note: Depreciation*Tax(%) is again an approximation to the actual tax savings being enjoyed by the Company. If the financial analyst has detailed calculation of tax depreciation, then it might better to use that.

So under Formula (2) we have EBITDA and Depreciation Tax Shield. Knowing the size depreciation tax savings is relevant in certain industry going heavy on depreciable assets.

If you are EBIT lover, then you still start with EBITDA, as shown below.

Free Cash Flow = (EBITDA – Depreciation)(1- Tax(%)) + Depreciation – Capex – change in NWC…(3a) or

Free Cash Flow = EBIT (1-Tax(%)) + Depreciation – Capex – change in NWC ……(3b)

Why we need to add back the depreciation under formula (3) above?

As you could see either (EBITDA- Depreciation) or EBIT, both has included depreciation component which is not a cashflow, this is why we need to put it back by adding depreciation after calculating (EBITDA – Depreciation) (1-Tax(%)) or EBIT (1-Tax(%)).

However, you might a bit confused since there is tax element in the depreciation. To answer that, we could expand formula (3a) to prove that by adding back the depreciation, it will be gone from FCF formula.

Formula (3a)

Free Cash Flow = (EBITDA – Depreciation)(1- Tax(%)) + Depreciation – Capex – change in NWC

We could re-write :

FCF = EBITDA (1-Tax(%)) – Depreciation (1-Tax(%)) + Depreciation – Capex – change in NWC.

FCF = EBITDA (1-Tax(%)) – Depreciation + Depreciation*Tax(%) + Depreciation  – Capex – change in NWC

We could cross out both Depreciation above since it is + and -, to be simpler formula:

FCF = EBITDA (1-Tax(%)) + Depreciation*Tax(%)) – Capex – change in NWC, which is the same with Formula (2) above.

You might ask how about using Net Income, since this is the Net Income that is normally what the financial analysts in the published financial statements by the public listed companies or financial institutions? Net Income could also be used to build the FCF, as all roads lead to Rome. We need to remember that FCF is the unlevered concept, which the financing is 100% by equity, no debt at all. Net Income is a levered concept, so it means we need to bring this levered Net Income to unlevered one. As Net Income is after interest expense, then we need to add this back. However, as interest expense is allowed to be deductible by the tax regulations, to get the assessable income of the company, then we need to consider the after-tax interest expense, instead of only interest expense. As long as EBIT is positive, in general, the presence of the interest expense will give the company the interest tax shield, because it lowers the company’s assessable income for tax purposes.

When we add back Net Income + Interest Expense (1-Tax), then we have:

Net Income + Interest Expense (1-Tax) = EBIT (1-Tax(%))

Once we have EBIT (1-Tax(%)), this will lead us to Formula (3b), which is we just have to add back the Depreciation to get FCF, as shown below.

Free Cash Flow = EBIT (1-Tax(%)) + Depreciation – Capex – change in NWC ……(3b)

So, if we start with Net Income, the whole formula for FCF is as folows:

Free Cash Flow = Net Income + Interest Expense – Interest Expense*Tax(%) + Depreciation – Capex – change in NWC…(3c)

As a closing note, in the valuation using multiple method, EBITDA multiple and FCF multiple might general similar value estimates, when there are no extraordinary capex or investments in net working capital.

Note:

FCF = Free Cash Flow (to the Firm), or sometimes it is written as FCFF, to differentiate it from Free Cash Flow to the Debt holders or Equity holder.

EBITDA = Earnings Before Interest, Tax and Depreciation and Amortization, or = Revenue – cash Costs

EBIT = Earnings Before Interest and Tax

Capex = Capital expenditure, the investments in fixed assets or intangible assets

NWC = Net Working Capital

Another thing to do is reconciling FCFF to the Statement of Cash Flows, which just remove out the change in cash balance from FCFF.

The next question, is why we need to remove out the cash balance change from FCFF?

My quick answer typically will be:

Statement of Cash Flows is the Cash Flow Statement which explains away the movement of the cash balance from the beginning of the year to the end of the year, by categorizing the components into 3 : Operations, Investing and Financing. As it is explaining the movement of cash balance, then the cash movement should not be included the component of changes of cash flow.

However, when it comes to FCFF calculation, any addition to the cash balance (higher balance at the end of the year), should be deducted from neutralized, or deducted from the Cash Flow Statement as it is already part of either cash flow from Operations, and/or Investing, and/or Financing.

So the formula to draw from Cash Flow Statement to FCFF will be:

FCFF = Cash Flows from/(used in Operations) +/- Cash Flow from Investing + After-tax interest expense -/+ changes in cash balance (Note : higher balance of cash will be minus, and lower balance at end of year will be plus to this formula).

This “After-tax interest expense” in the above formula needs a footnote as well:

1. This is assumed full-shielded interest expense which EBIT exceeds total interest expense incurred in that period; and

2. this is assumed that interest expense is shown as part of Cash Flows from Operating Activities (Note: IFRS allows the company to put under Operating or Financing Activities). If interest expense is shown as part of Financing Activities, then need to remove the after tax interest expense from the above formula.

Another question which is still related to FCF, EBITDA and valuation is why in the Multiple Valuation, analysts would prefer using EBITDA instead of FCF, though FCF is extensively used in the Discounted Cash Flow valuation.

I could think at least three reasonable arguments for this:

  1. EBITDA is not that volatile as that of FCF. Under the contents of FCF, we could find two “discretionary” expenditures, they are Capital Expenditures and Changes in Net Working Capital. EBITDA could be said is relatively shielded from such discretionary decisions. In early years of many companies, it is normal to see that FCF will be negative, as the Company has to re-invested in capital expenditures and working capital to pursue any positive growth opportunities. I guess, this makes sense as it will take money to make money, right? The speed of investments is higher than the speed that the Company could generate the positive cash flows from operations activities.
  2. If we know that investment in capital expenditures and working capital is so critical then why we don’t just include this, which means FCF will make more sense. Of course, there is a price that we have to pay if we rely on EBITDA multiple. We only can use EBITDA multiple by ignoring capital expenditures and investment in changes in net working capital, if we believe that such investments have no more positive Net Present Value on average and on long term. If we don’t have such belief, then we might come back to FCF to consider, or other Metrics to use.
  3. EBITDA is good since it measures the ‘cash’ earnings being generated by current operations, existing assets-in-place. Here we don’t consider the value of the Company’s new investments. So it is the “as-it-is” valuation.

Feel free to comment.

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