WHEN INTEREST SHOULD BE INCLUDED IN FREE CASH FLOW CALCULATIONS - SUPPLEMENT TO "IS EBITDA THE RIGHT ENTERPRISE VALUATION METRIC FOR M&A BUYERS..."

In traditional Free Cash Flow (FCF) calculations, interest expense is excluded because it’s viewed as a cost tied to a company’s capital structure, not its operations. However, in certain scenarios, interest should be treated as an operational cost and deducted from FCF to present a more accurate view of cash flow. This is particularly true when interest arises from financing working capital needs rather than long-term debt or structural financing decisions.

1. The Standard FCF Assumption

The typical FCF formula excludes interest:

? Interest on Long-Term Debt: Excluded because it reflects a financing decision, not a cost of core operations.

? Taxes: Included because they represent an unavoidable operational cash outflow.

However, not all interest is created equal. Interest tied to working capital financing is different.

2. When Interest Becomes an Operating Expense

In certain businesses, short-term financing of working capital (e.g., revolving credit facilities, asset-backed loans on inventory or receivables) incurs interest that is effectively a cost of operations. In these cases:

? Short-Term Inventory Financing: Retailers or manufacturers may finance large seasonal inventory builds through short-term loans.

? Receivables Financing: Businesses with long accounts receivable cycles may use asset-backed financing to bridge cash gaps.

If interest on these loans is recurring, essential, and tied directly to generating revenue, it is more akin to an operating expense than a capital structure cost.

Key Question:

Would removing this interest expense from FCF misrepresent the cash required to sustain the business?

If the answer is yes, this interest should be deducted in the FCF calculation.

3. Adjusted Free Cash Flow Calculation

In such cases, an Adjusted Free Cash Flow (Adjusted FCF) calculation is more appropriate:

This approach ensures:

? Operational interest costs are accounted for.

? FCF reflects the true cash available after sustaining operations and managing working capital.

4. Examples by Industry

Retail and Seasonal Businesses:

Retailers often rely on short-term loans to finance seasonal inventory purchases. Interest on these loans is a necessary operating cost tied to generating revenue during peak seasons.

Manufacturing with Long Receivables Cycles:

Manufacturers with extended payment terms from customers may need financing to cover cash shortfalls while awaiting payments. Interest on these loans supports daily operations.

In contrast:

? Interest on long-term loans or bonds remains excluded from FCF since it reflects capital structure choices rather than operational necessity.

5. Why This Matters in M&A Transactions

Accurate Valuation:

If interest on working capital financing is excluded from FCF in capital-intensive or seasonal businesses, cash flow will be overstated, leading to overvaluation.

Diligence Focus:

During financial due diligence:

? Buyers should dissect interest expense line items to understand their origins.

? Interest related to operational financing (working capital) should be separated from structural debt interest.

Strategic Adjustments:

Savvy buyers may use Adjusted FCF in valuation models to:

? Accurately price businesses with high working capital financing needs.

? Avoid misjudging cash flow sustainability.

6. Final Takeaway

Interest isn’t always just a capital structure cost. When it directly supports working capital—like financing inventory builds or covering receivables—it functions as an operational cost and should be treated as such in Free Cash Flow calculations.

For buyers and investors:

? Always analyze the origin of interest expenses.

? Create Adjusted FCF models when working capital financing is significant and recurring.

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