The Bridge from Adjusted EBITDA to Free Cash Flow to the Firm

A business at the start of this bridge has earnings a fund will pay a multiple for. Adjusted EBITDA is proven, the owner is no longer indispensable, and the customers deal with the company. What adjusted EBITDA cannot say is how much of those earnings the business can hand back to the people who finance it. EBITDA is earnings before the business replaces its equipment, before it funds the receivables and stock its sales require, and before it pays its own taxes. Each of those is a real use of cash. The third bridge deducts them one span at a time until what is left is free cash flow to the firm: the cash the business produces for everyone who has capital in it, lenders and owners together.

The deductions come in the order a business usually gains sight of them. Capital spending comes first, because it is visible in the asset purchases. Working capital is second, since it only shows up when the balance sheet is read month by month. Taxes at the level of the entity come third, because they depend on how the business is structured. The last span is proof that the resulting cash flow can be forecast, because the buyer at the next anchor is paying for a forecast.

A buyer who models

Underwriting changes here from multiplying an earnings line to modelling a stream of cash. The buyer has stopped asking whether the earnings are real and now asks how much of them can be taken out every year without starving the business. Such a buyer has an analyst who rebuilds the history of capital spending, negotiates a level of working capital to be delivered at closing, prices every obligation that behaves like debt, and runs a discounted cash flow beside the multiple.

This buyer is also more diversified than the one at the previous anchor, and prices risk as a cost of capital instead of as a personal exposure. And this buyer will not pay for EBITDA that fails to turn into cash. When a business's earnings are consumed by the equipment it has to replace, or tied up in customers who pay slowly, it is worth less to this buyer than its EBITDA suggests, however reliable the EBITDA is.

The starting point: inspecting adjusted EBITDA

The bridge opens by inspecting the second bridge's deliverables line by line. The statements come first, three years of reviewed accrual accounts with a proof of cash and a reconciliation to the returns. Then the evidence that the business runs without its owner: the management team, the record of the owner's absence, the written procedures. Then the evidence that the earnings are clean and belong to the company, in the schedule of adjustments, the related-party arrangements, the customer schedule, the company contracts and the liabilities file. Last come the sales engine's record and the inputs the previous valuation used. A business that fails a line goes back to the first span of the second bridge whose measure it cannot show.

The inspection also lists the ways a business slips off adjusted EBITDA, and most of them are the second bridge's hard-won changes coming undone. The owner drifts back into a seat, or a manager leaves and is not replaced, or a large account finds its way back to the owner's phone. Adjustments multiply, the statements slip back to a cash basis, one customer grows until it is the business, and the owner starts selling again.

Four spans

The first span runs from adjusted EBITDA to EBITDA less maintenance capital spending: earnings after the spending that keeps the business running, separated from the spending that grows it. Capex Discipline fixes what counts as capital spending and splits three years of it into maintenance and growth, so the deduction a buyer takes is the one the records support. Asset Stewardship records what the business runs on, the condition it is in and what it will cost to keep running, which lets the maintenance deduction look forward as well as back. The span is crossed when a buyer accepts the split and the assets are registered, rated and on a replacement plan.

The second span runs to cash conversion, earnings less capital spending less the change in working capital. Working Capital Management defines net working capital consistently, sets the level the business normally needs to carry, and manages receivables, payables and inventory to targets, so the change a buyer deducts is small, predictable and agreed. Balance Sheet Quality checks that the balance sheet behind that figure is collectible, saleable and complete. Receivables will be paid, stock exists and will sell, revenue is recognized when it is earned, and every obligation a buyer will treat as debt is listed before the buyer finds it. Cash Visibility then measures the cash itself, through a monthly cash flow statement, a rolling weekly forecast whose accuracy is tracked, and a yearly cash conversion figure with every gap explained. This span is crossed when there is a working-capital peg the business manages to, a balance sheet that would survive review, and cash forecast every week.

The third span runs to NOPAT, net operating profit after tax, which is operating profit after cash taxes at the level of the entity. Tax Position establishes the tax the business's operating profit bears, reconciled to the returns and free of unquantified exposure. Entity Structure draws the boundary of what is being valued: which entities hold the operating assets, contracts, people and licences, how money moves between them, and what falls inside the perimeter of a sale. The span is crossed when the tax position is understood and the perimeter is written down.

The fourth span runs to free cash flow to the firm. Budgeting proves the business can plan its year and hit the plan, with budgets built by the leads and variances explained every month. Forecast Model builds an integrated forecast from the same drivers the history shows, and its discounted value reconciles to the multiple method, so a modelling buyer starts from the seller's model. Reinvestment Return shows what the business earns on the cash it reinvests, which makes forecast growth the product of reinvestment and return instead of an assumption. Enterprise Value File produces the inputs the valuation consumes. The span is crossed when the budget record makes a forecast credible and the forecast produces a value a buyer can test without having to rebuild it.

The peg

The second span introduces a mechanism that shapes the whole bridge, the working-capital peg. When a business is sold, buyer and seller agree the level of working capital, receivables plus inventory less payables, that it normally needs to run, and the seller delivers the business at closing with that level in it. If working capital falls short of the peg, the price falls by the shortfall, dollar for dollar. If it exceeds the peg, the buyer pays for the excess.

The peg is why working capital has to be managed to a level and cannot simply be squeezed before a sale. A seller who collects every receivable and runs stock down in the months before closing does not keep the cash, because the shortfall against the peg comes straight off the price. The peg is also why the level matters so much in negotiation. Set from the business's worst month, or from a year in which collections slipped, it is a level the business has to fill with its own cash at closing. Set from managed days, with the seasonal pattern documented, it is a level the business delivers in the ordinary course.

The same logic shows why working capital management produces real value, beyond a better negotiation. A business that runs on fewer days of working capital needs less of it, permanently. The cash released when the days fall is cash the owner can take out before the peg is set, and the lower level is the level the peg is then set at. The buyer pays for a business that needs less capital to produce the same cash, and the owner has already been paid the difference.

One number for the whole bridge

A modelling buyer often summarizes this bridge in one ratio: cash conversion, free cash flow as a share of EBITDA. When a business converts most of its EBITDA into free cash, its earnings are largely available to the people who finance it. When it converts a small share, its equipment, its customers' payment habits and its taxes are consuming the earnings.

The ratio earns its place because it is hard to flatter. Adjustments can move EBITDA, and nothing comparable moves cash. Every span on the bridge changes the ratio, and the buyer reads the business's own figure for it, measured each year with every gap explained by Cash Visibility, before reading anything else.

What the work is worth

The framework values the work on this bridge exactly as the valuation at its exit anchor values a business: as a change in cash flow or in growth, discounted at the cost of capital, or as a change in the probability or size of a named scenario. Nothing is valued by multiplying earnings, and no driver is credited with moving the cost of capital.

Most of the value on this bridge sits in capital turnover, the revenue the business earns on each dollar of capital it carries. Bringing working capital to a managed level, planning maintenance before it is forced by a failure, and bringing operating assets inside the perimeter on known terms all shrink the capital the business has to hold. Each raises the return the business earns on its capital without any change in its margin, which makes this the first bridge on which much of the value is made on the balance sheet.

The framework stays strict about what does not count as value. A growth purchase reclassified out of maintenance with no change in spending changes what a buyer deducts and leaves what the business pays untouched. When the business's own maintenance plan replaces a buyer's harsh estimate, the difference is a difference in a recorded figure until the spending itself changes. And the gap between a penal tax rate a buyer might assume and the rate the business actually pays changes the buyer's model while the business's tax stays the same. Each of these moves the price without moving the value, and each sits in a separate column outside the ranking. Budgeting and Cash Visibility carry no rank at all, since their whole effect is to make the business's cash flow and plans verifiable.

The order of the work

The ranking rule is value moved per unit of effort and capital, counting recurring effects at their discounted value and one-time effects at face. For a typical business at this bridge it puts Working Capital Management first.

The cash it releases is real, arrives once and is large relative to the effort, and the smaller working-capital build on every future dollar of growth recurs for as long as the business grows. In the illustration, removing ten days of working capital from a business with $12 million of revenue releases about $329,000 at once, and because the business grows 5 percent a year, it also absorbs about $16,000 less working capital every year. Valued together at a 12 percent cost of capital, the change is worth about $564,000.

Reinvestment Return comes second. It is the only operating driver on the bridge that creates growth value, and a register that stops projects earning below the cost of capital raises the return on every dollar reinvested after it. Asset Stewardship is third, because clearing deferred maintenance on a schedule avoids the premium of emergency replacement and takes the risk of a capital overrun out of the downside case, and both of those change what the business spends. Entity Structure is fourth, followed by the portfolio lever, buying or selling a line, tested as reinvestment at its own return. Balance Sheet Quality, Tax Position and Capex Discipline follow, because much of what each does is a price effect, and only the cash recovered, the penalties avoided or the spending avoided count as value. Forecast Model and Enterprise Value File come last on value, because they narrow the uncertainty around the number without moving it.

Incentives follow the ranking as they did on the earlier bridges. Each ranked driver's seat is paid against its own measure, from value the business has earned in the period. The finance lead is paid for working capital held at or below the peg. Each growth project's sponsor is paid for the project's return above the cost of capital, measured once the project has had time to show a return and again after it has settled. The operations lead is paid for deferred maintenance cleared. Nothing is paid for a price effect.

The destination: free cash flow to the firm

Free cash flow to the firm is net operating profit after tax, plus depreciation and amortization, less capital spending, less the change in working capital. The same figure appears as unlevered free cash flow in quality-of-earnings reports, lender packs and broker documents. The two names describe one number from different sides. One says who it belongs to, every provider of capital before any is paid. The other says what it leaves out, the effects of borrowing.

The underwriter is a buyer who models instead of multiplying, will not pay for EBITDA that does not become cash, and is diversified enough to price risk as a cost of capital. The valuation at this anchor, set out in the essay on what free cash flow to the firm is worth, is the first in the framework where the discounted cash flow governs and the multiple is the cross-check. The deliverables follow the four spans. The first leaves a classified capital spending schedule and an asset register with a replacement plan. The second leaves a working-capital definition and peg, a clean balance sheet with a schedule of debt-like items, and a cash forecast with a record. The third leaves a reconciled tax position and a written perimeter. The fourth leaves a budget record, an integrated forecast, a register of reinvestment and its returns, and the inputs the valuation consumed.

Who stops here

A business whose buyers will set their own capital structure should stop at free cash flow to the firm. A fund or a strategic buyer that models cash will decide for itself how much debt to put on the business, and has no use for a seller who has already arranged it. The next bridge, which carries the business to free cash flow to equity, is worth crossing only when the sale will be leveraged and the lender needs to see debt already carried, or when the owner intends to keep the business and borrow against it.