Acquirers of non-financial services companies tend to focus on various definitions of cash flow and value. Because acquirers typically employ a different capital structure than the seller, value generally refers to the value of total invested capital (“TIC”), or the value of the firm’s operations before considering the capital structure. Value for equity holders is derived by subtracting the target’s capital structure debt (note: short-term working capital borrowings would not be considered capital; however, to the extent such borrowings exist, operating cash flow should be reduced for interest expense on revolver loans.)
Cash flow measures including earnings before interest, taxes, and depreciation/amortization (“EBITDA”), which is sometimes referred to as gross cash flow, represent a proxy for cash earnings before capital expenditures and debt service. Operating cash flow is generally defined as EBITDA less capital expenditures (in effect “cash EBIT”). Pricing multiples which are based upon cash flow (or earnings) measures before consideration of the capital structure, such as EBITDA and EBIT, refer to overall firm value, not the value of the residual equity. Net free cash flow represents residual cash flow available to common shareholders after capital expenditures, debt service requirements, and net working capital requirements have been met. While cash flow is an important consideration for any security analysts, LBO sponsors, private equity investors and other investors who typically use a large amount of debt to finance transactions are highly focused on these cash flow concepts rather than reported GAAP net income.
Reprinted from Mercer Capital’s Transaction Advisor – Vol. 1, No. 2, 1998.