Class Closeout

What do CFO/EBITDA and FCF/EBIT tell you?

Definitions

  • CFO = Cash Flow from Operations (from the cash-flow statement).
  • EBITDA = Earnings Before Interest, Taxes, Depreciation, Amortization (income statement).
  • EBIT = Operating income (after D&A).
  • FCF (to firm) ≈ EBIT·(1–T) + D&A – Capex – ΔNWC.

Ratios

  • CFO / EBITDA → cash conversion of EBITDA.
    • High and stable (e.g., ≥90% over a cycle) says accrual earnings are close to cash; WC isn’t a sink; SBC/interest/taxes not distorting CFO.
    • Low or volatile flags: working-capital build (inventory/AR up), aggressive revenue recognition, rising cash taxes/interest, restructuring.
  • FCF / EBIT → cash yield on operating profit after growth reinvestment.
    • If near 100% in a growth business, you may be underinvesting (Capex/ΔNWC too low).
    • If ~40–70% for a durable grower, that’s common: taxes + required Capex + WC consume a chunk of EBIT.

Toy example (one year)

  • EBITDA 120, D&A 20 → EBIT 100.
  • Taxes (25%) on EBIT = 25.
  • Capex 30, ΔNWC 10 (investment).
  • CFO = EBITDA – ΔNWC – cash taxes – cash interest ± other = 120 – 10 – 25 – 0 = 85 (simplified).
  • FCF = EBIT(1–T) + D&A – Capex – ΔNWC = 75 + 20 – 30 – 10 = 55.
  • CFO/EBITDA = 85/120 = 71% (WC + taxes biting).
  • FCF/EBIT = 55/100 = 55% (normal if you’re funding growth).

Use these as time-series and vs. peers, not as single-year absolutes.

Rates hit you two ways: earnings tailwind on cash, headwind via discount rate

A) Interest income on cash & marketable securities

  • If cash & short securities = $150B, a +100 bps (1.00%) move in short rates adds $1.5B pre-tax interest income when assets reprice.
  • After 20% tax → $1.2B net.
  • With 15.5B diluted shares, EPS +$0.08.
  • Caveats:
    • Repricing/duration: not all cash resets day-1 (T-bills roll; bond funds have duration).
    • Classification: AFS/HTM marks can move OCI/equity rather than income.
    • Netting: If you also have floating-rate debt, interest expense rises too.

B) WACC rises with rates and risk premia → lower PV

  • WACC = w_e·r_e + w_d·r_d·(1–T). When the risk-free rate or credit spreads go up, r_e and r_d go up → WACC ↑.
  • In a growing perpetuity V=FCF1r−gV = \frac{FCF_1}{r-g}V=r−gFCF1, a 100 bps rise in r with g unchanged widens the spread.

Impact example (terminal value only)

  • FCF1=$100BFCF_1 = \$100BFCF1=$100B, r=7.5%, g=4.0% → spread = 3.5% → V=100/0.035=$2.86TV = 100/0.035 = \$2.86TV=100/0.035=$2.86T.
  • If r=8.5% (↑100 bps), same g=4.0% → spread = 4.5% → V=100/0.045=$2.22TV = 100/0.045 = \$2.22TV=100/0.045=$2.22T.
  • Down ~$0.64T from a 100 bps move—this is why the discount-rate effect overwhelms the EPS tailwind from cash.

Debt lowers WACC (tax shield) until risk bites

  • Interest is tax-deductible → r_d·(1–T) is the after-tax cost, pulling WACC down as you add some debt.
  • But more leverage makes equity riskier; r_e rises, and beyond a point expected distress costs (downgrade, covenants, refinancing risk, lost flexibility) push WACC up.
  • Shape: WACC tends to be U-shaped in leverage—there’s an interior minimum (target structure), not “more debt is always better.”

Simple takeaway: Use enough debt to benefit from the tax shield without threatening strategic optionality or ratings you care about.