The ease to calculate EBITDA, given it is an income statement number, make it a common metric to use when comparing organizations and industries. EBITDA is also a proxy for a company’s free cash flow (FCF) and is used in lieu of calculating FCF metrics. We wanted to take a look at FCF metrics in technology services to see how these cash flow metrics relate to EBITDA.
In the case of technology services companies that have low levels of capital expenditures (CapEx) and therefore low levels of depreciation and amortization (D&A), EBITDA tends to be close to EBIT / Operating Income, making EBITDA a very good metric to look at when trying to understand the Operating Income of a tech services business. Other industries with relevant CapEx have a wider gap between EBITDA and their Operating Income sibling.
One way for executives to compare their company’s metrics and to try to understand the relationship between EBITDA and FCF is to look at publicly-traded companies. With this data, a management team can benchmark against other mature examples.
Let’s start by defining some terms so we have a common understanding on these. FCF can be calculated in multiple ways but we will calculate it by deducting Capital Expenditures from Cash from Operations (both from the cashflow statement).
Similar to how we look at EBITDA Margin (EBITDA over Revenue), we will define FCF Margin as FCF divided by Revenue.
Lastly, FCF Conversion is how we connect FCF with EBITDA.
Below is a list of technology services publicly-traded companies and their respective EBITDA and FCF metrics.
We can observe similar FCF Conversion metrics across the different tech services categories in the 60%-70% range (meaning on average FCF is 60%-70% of EBITDA). EBITDA margins vary across the different categories with staffing having lower EBITDA margins and offshore IT services sporting the highest EBITDA margins. FCF margins follow a similar pattern as EBITDA margins.
To put tech services names intro perspective we created a table with a sprinkle of other industries and companies.
At Alten Capital we focus on investing in business and technology services companies. Understanding the financial profile of the industries and organizations we focus on is relevant for us and our partners. Please reach out to us to explore how we can partner.