Hi, if I encounter the situation where I see EBITDA margin compression but an explosion in the FCF margin, does this indicate that the company could be capitalizing on a number something large? If so, I would be grateful if you can give examples of how this can occur. It would be helpful if you can explain this by breaking down the components of FCF and EBITDA which makes them different so that I can see where the discrepancy is causing the problem. Thanks.
As you asked, first let’s see the calculation of EBITDA and FCFF (FCF is meant for FCFF).
EBITDA = Revenues - Cost of Sales - Administrative and OHD Expenses
FCFF = EBITDA(1 - tax rate) + Dep(Tax rate) - FCInv - WCInv
So… yeah, there are differences !
The strong components of FCFF that can make it differ widely from EBITDA are Cash Flows from Investment Activities (FCInv), Working Capital Investments (WCInv), and Taxes.
For example:
(1) The company sold a fixed asset (a factory), so the FCFF explodes because FCInv goes positive, but EBITDA remains constant. EBITDA does not capture that transaction.
(2) The company made a great deal with suppliers and got a 100% credit purchases for 180 days. WCInv reduces significantly so FCFF bumps up but EBITDA remains constant. Note that this does not imply FCFF would be higher than EBITDA in nominal units ($ amount).
(3) A beneficial change in the tax regulation allows companies to depreciate fixed assets (like buildings) in a much quite faster pace, so depreciation expenses in P&L increase significantly reducing Taxable Income. Taxes paid are reduced significantly. FCFF will bump up, but EBITDA will remain constant.
I can imagine another 20 cases right now, but we have a good start with those above. Keep thinking.
Hope this helps.
Excellent post and I really appreciate that you explain the differences by giving concrete examples and it helped me a lot since I don’t have a rigorous business background. Actually, it would be great if you can share with me your 20 or so examples that you have in mind (via private message or public post). The reason why I ask this is because from the face of the aforementioned relationship between FCF margin and EBITDA margin, it does not seem that this growth in FCF margin is sustainable. This motivates me to ask for cases where this relationship is indeed sustainable.
I just thought of an example: A company could experience a negative mix shift in its business resulting in lower EBITDA margins but the business could be mitigated by much lower CapEx needed to be spent to keep itself growing. As such, the opposing relationship with the FCF margin and EBITDA margin, in this case, can be said to be sustainable.
Let me know what you think and if you have other (sophisticated) examples please share! Thanks for your time.