Cash Flow Statement
Free cash flow, capex, and why cash matters more than earnings in PE
~20 min read
If the income statement tells you how a company performed on paper and the balance sheet tells you what it owns and owes, the cash flow statement tells you what actually happened in cash. In PE, cash is king. A company can report rising revenue and growing EBITDA while simultaneously burning cash, and a PE buyer who does not catch this disconnect will overpay.
The cash flow statement reconciles the gap between accrual-based accounting (the income statement) and economic reality. It answers the fundamental question: How much cash did the business generate, and where did it go?
The Three Sections of the Cash Flow Statement
Operating Cash Flow (CFO)
Cash generated from the company's core business operations. Starts with net income and adjusts for non-cash items (D&A, stock-based compensation) and changes in working capital. This is the most important section for PE because it measures the cash the business produces from doing what it does.
Investing Cash Flow (CFI)
Cash spent on (or received from) long-term investments. The largest item is usually capital expenditures (capex). Also includes cash used for acquisitions or received from asset sales. Negative CFI is typical for healthy, growing businesses that are investing in their future.
Financing Cash Flow (CFF)
Cash flows related to the company's capital structure. Includes debt borrowings and repayments, equity issuances and buybacks, and dividend payments. In a PE context, this section changes dramatically at close as the acquisition debt is put in place and the old capital structure is retired.
Operating Cash Flow (CFO)
Cash generated from the company's core business operations. Starts with net income and adjusts for non-cash items (D&A, stock-based compensation) and changes in working capital. This is the most important section for PE because it measures the cash the business produces from doing what it does.
Investing Cash Flow (CFI)
Cash spent on (or received from) long-term investments. The largest item is usually capital expenditures (capex). Also includes cash used for acquisitions or received from asset sales. Negative CFI is typical for healthy, growing businesses that are investing in their future.
Financing Cash Flow (CFF)
Cash flows related to the company's capital structure. Includes debt borrowings and repayments, equity issuances and buybacks, and dividend payments. In a PE context, this section changes dramatically at close as the acquisition debt is put in place and the old capital structure is retired.
Free Cash Flow: Levered vs. Unlevered
Free cash flow (FCF) is the cash left over after the business has funded its operations and maintained its asset base. There are two versions that serve different purposes:
Unlevered Free Cash Flow (UFCF): The cash the business generates independent of its capital structure. This is the starting point for DCF valuations and for assessing the intrinsic earning power of the operations.
UFCF = EBITDA - Taxes (on EBIT) - Changes in Working Capital - Capital Expenditures
Levered Free Cash Flow (LFCF): The cash available to equity holders after all obligations, including debt service, have been met. This is what matters for measuring equity returns in an LBO.
LFCF = UFCF - Interest Expense (tax-adjusted) - Mandatory Debt Repayment
In PE, unlevered FCF tells you how good the business is. Levered FCF tells you how much cash is available to pay down acquisition debt and return to equity investors. A strong LBO candidate generates significant LFCF because excess cash accelerates debt paydown, which is one of the primary drivers of equity returns.
Unlevered Free Cash Flow
Unlevered FCF measures the cash produced by the business before any debt service. It is capital-structure-neutral, making it the standard input for DCF analysis. 'Cash taxes on EBIT' means the tax the company would pay if it had no interest deductions (since interest is a financing choice, not an operating one).
Maintenance Capex vs. Growth Capex
Not all capital expenditures are the same, and distinguishing between the two types is critical for PE analysis:
- Maintenance capex is the spending required to keep the business running at its current level. Replacing worn equipment, maintaining facilities, upgrading essential software. If the company stopped this spending, its revenue and margins would eventually decline. Maintenance capex is a real cost that should be subtracted from EBITDA to get a true picture of recurring cash generation.
- Growth capex is spending on new capacity, new locations, or new capabilities that will generate incremental revenue. Opening a new manufacturing line, building out a new data center, or expanding into a new geography. Growth capex is discretionary and should be evaluated on a return-on-investment basis.
The distinction matters because a company that reports $20M in EBITDA and $12M in total capex might appear cash-flow-poor. But if $8M of that capex is growth-related and discretionary, the maintenance FCF is actually $20M - $4M = $16M. The growth capex is a choice, not an obligation, and a new owner could scale it up or down depending on the opportunity.
Companies rarely disclose this split explicitly. PE buyers must reconstruct it through management interviews, asset inspection, and comparison to industry benchmarks.
Cash Conversion: The Quality Test
Cash conversion measures how efficiently a company translates its accrual-based earnings into actual cash. The most common ratio in PE:
Cash Conversion = Operating Cash Flow / EBITDA
A ratio above 80% is generally considered strong. A ratio consistently below 60% is a warning sign that the company's reported earnings are not translating into cash.
Common reasons for poor cash conversion:
- Rapid receivable growth: Revenue is growing, but customers are paying slowly. The company is funding its growth with its own working capital.
- Inventory buildup: The company is producing more than it sells, tying up cash in unsold goods.
- Large non-cash revenue items: Revenue recognized under percentage-of-completion or long-term contracts may not correspond to cash collected.
- Capitalized costs: The company capitalizes expenses (such as software development) that might be more appropriately expensed, flattering EBITDA while the actual cash has already left the building.
For PE buyers, poor cash conversion undermines the entire LBO thesis. If the business cannot convert its EBITDA into cash, it cannot service acquisition debt, and the leveraged return model breaks down.
Cash Conversion Reality Check: Two Companies Compared
Company A (software): $30M EBITDA, $28M operating cash flow. Cash conversion = 93%. SaaS businesses with recurring subscription revenue, low capex, and prepaid annual contracts often exhibit exceptional cash conversion. Customers pay upfront, and the company recognizes revenue over time. This is the profile PE buyers love.
Company B (industrial manufacturer): $30M EBITDA, $17M operating cash flow. Cash conversion = 57%. Investigation reveals: $6M in receivables growth (customers on extended payment terms to win contracts), $4M in inventory buildup (new product line pre-launch), and $3M in timing differences on accrued expenses. Of these, the inventory buildup may normalize post-launch, but the receivable growth reflects a structural shift toward longer payment terms that will persist.
Both companies report the same EBITDA, but Company A generates $11M more in operating cash flow. At a 10x EBITDA valuation ($300M enterprise value for both), Company A is a far superior acquisition candidate for an LBO because it can service significantly more debt.
Composite example based on typical PE due diligence scenarios
Quiz: Cash Flow Statement
6 questions · ~3 min