Cash Flow Analysis in Financial Due Diligence
How FDD analysts perform cash flow analysis: the link between EBITDA and cash generation, cash conversion, and what low cash conversion signals.
Cash flow analysis is a critical but often underappreciated component of Financial Due Diligence. EBITDA tells you about profitability. Cash flow tells you whether the business actually generates cash — and whether the EBITDA is real. A business with strong reported EBITDA and poor cash conversion is a significant risk for any buyer.
Why Cash Flow Analysis Matters in FDD
The primary question a buyer asks is: "If I buy this business at 8x EBITDA, will I generate the cash returns I need to service my debt and earn a return on equity?"
This question cannot be answered by EBITDA alone. Cash flow analysis bridges the gap between accounting profits and actual cash generation.
From EBITDA to Free Cash Flow
The standard bridge from EBITDA to free cash flow runs as follows:
EBITDA
– Change in Net Working Capital (cash absorbed or released)
– Capital Expenditure (maintenance + growth)
– Cash taxes
– Cash interest (on financial debt)
– Other cash items (one-off payments, restructuring cash costs)
= Free Cash Flow (Levered) / Unlevered FCF before debt service
Each line tells a specific story:
- Working capital change: Is the business absorbing cash as it grows, or releasing cash?
- Capex: Is the business capital-intensive? Is maintenance capex adequate?
- Cash taxes: Are there tax benefits (losses carried forward, timing differences) that will reverse?
- Cash interest: How much of EBITDA is consumed by debt service?
The Cash Conversion Ratio
Cash Conversion = Free Cash Flow / EBITDA
A ratio above 70-80% is generally considered healthy. A ratio consistently below 50% warrants investigation.
Common reasons for low cash conversion:
- High capex requirements (capital-intensive businesses)
- Working capital growth absorbing cash (fast-growing businesses with longer cash cycles)
- One-off cash outflows (restructuring costs, settlement payments)
- High cash taxes relative to accounting taxes (no deferred tax shield)
What FDD Analysts Do in Cash Flow Analysis
Step 1: Build the Cash Flow History
Reconstruct cash flows from the statutory accounts:
- Operating cash flow (EBITDA − working capital change)
- Investing cash flow (capex, acquisitions, disposals)
- Financing cash flow (debt repayment, dividends, shareholder loans)
Step 2: Identify Distortions
Look for one-off cash items that inflate or depress cash conversion in specific periods:
- Large upfront customer receipts
- Deferred payment of liabilities
- Sale of assets
Step 3: Calculate Normalised Cash Flow
Apply a similar normalisation process to cash flow as to EBITDA, stripping out one-off items to arrive at a representative sustainable cash generation level.
Step 4: Capex Assessment
Separately assess maintenance capex (needed to keep the business running) versus growth capex (to expand). This is covered in more detail in the maintenance capex post — but the starting point is reviewing the fixed asset schedule and management's own categorisation of capex.
Conclusion
Cash flow analysis is the final check on whether EBITDA translates into real economic value. Buyers who pay for EBITDA without checking cash conversion can overpay materially. FDD analysts who perform this analysis rigorously provide genuine protection.
The Transaction Services Interview Programme (€119.99, one-time) includes cash flow analysis modules with Excel models and real FDD case studies showing the EBITDA-to-FCF bridge. Get started today.