What Is Free Cash Flow Conversion?
Free cash flow conversion answers a simple question: for every dollar of reported earnings, how many cents of spendable cash does the business actually produce? In deal contexts the ratio is most often expressed as free cash flow divided by EBITDA, while equity analysts frequently use free cash flow divided by net income. Either way, a higher percentage means earnings are 'real' in cash terms.
Conversion is driven by how much of a company's earnings get consumed before cash reaches the bottom line — capital expenditures, cash taxes, cash interest, and swings in working capital all take their cut. Asset-light software businesses often convert 80% or more of EBITDA into unlevered free cash flow, while heavy industrials with big maintenance capex bills may convert less than half.
How to Calculate It
The levered build is: EBITDA minus capital expenditures, minus cash interest, minus cash taxes, minus any increase in net working capital, equals free cash flow. An unlevered version excludes interest so the metric reflects the business rather than its financing. Conversion is then simply that free cash flow figure divided by EBITDA for the same period.
Take a company with $100 million of EBITDA that spends $15 million on capex, pays $10 million of cash interest and $20 million of cash taxes, and absorbs a $5 million working capital build. Free cash flow is $50 million, so conversion is 50%. If a peer with identical EBITDA converts at 75%, it generates $25 million more in cash each year — a difference that compounds dramatically over a five-year hold.
Why It Matters in Deals and Careers
In a leveraged buyout, free cash flow conversion determines how quickly debt gets repaid, which is a primary driver of equity returns. Sponsors will pay richer multiples for high-conversion businesses and probe conversion intensely during quality of earnings work, since a persistent gap between EBITDA growth and cash generation often points to aggressive revenue recognition or ballooning receivables.
Credit investors care for the same reason: cash, not EBITDA, services debt. For candidates recruiting into private equity, leveraged finance, or credit roles, expect interview questions that ask you to walk from EBITDA to free cash flow and explain why two companies with the same earnings can deserve very different valuations. Conversion is usually the answer.
