To calculate free cash flow from EBITDA, take EBITDA, subtract the cash interest actually paid, subtract the cash taxes actually paid, subtract capital expenditures, and then adjust for the change in net working capital. That single line is the whole conversion. The difficulty is not the arithmetic. It is pulling the right number for each input, because for three of the four subtractions the figure on the income statement is not the figure you want.
The Formula in Order
- Start with EBITDA.
- Subtract cash interest paid.
- Subtract cash taxes paid.
- Subtract capital expenditures.
- Adjust for the change in net working capital (subtract increases, add decreases).
- The result is free cash flow.
EBITDA itself is not a GAAP line item, so you often have to build it. Start with operating income from the income statement and add back depreciation and amortization, which you will find on the cash flow statement or in the footnotes. Some companies publish their own EBITDA or an “adjusted EBITDA” figure in earnings releases or the management discussion section of the 10-K; if they do, check what has already been added back before you use it.
Cash Interest Paid
The income statement shows accrued interest expense, which includes non-cash items like amortization of debt issuance costs, accretion on discount bonds, and paid-in-kind interest that gets added to the loan balance instead of leaving the bank account. None of that is cash you’re losing this period.
Use the supplemental disclosure at the bottom of the Statement of Cash Flows, usually labeled “cash paid for interest.” Under ASC 230, companies using the indirect method are required to disclose it there or in the footnotes. For a company with plain vanilla debt, this figure sits close to the income statement number. For a company with convertible notes, zero-coupon bonds, or PIK toggle notes, the gap can be large enough to swing the whole free cash flow calculation. Always pull the cash figure.
Cash Taxes Paid
“Income tax expense” on the income statement is an accounting estimate that includes deferred tax provisions for timing differences between book and tax treatment. It may not resemble what the company actually wired to tax authorities. The number you want is in the same supplemental section of the cash flow statement: “cash paid for income taxes.”
Cash taxes in a given year rarely match a simple percentage of pre-tax income. Net operating loss carryforwards, credits, and state-level variation all pull the actual check away from the headline rate. Rather than reconstruct that, pull the disclosed figure.
If you are working backward from income tax expense because the direct disclosure isn’t broken out, you would add back the increase in deferred tax liabilities to approximate cash taxes. When accounting tax expense exceeds cash paid, the difference accumulates as a deferred tax liability, meaning the company held onto more cash than the income statement suggests. Pulling the direct “taxes paid” line is simpler and more accurate whenever it’s available.
Capital Expenditures
Capex sits in the investing activities section of the cash flow statement, typically as “purchases of property, plant, and equipment.” It is always an outflow, and you subtract the full amount.
This is the step that corrects EBITDA’s biggest distortion. Adding back depreciation treats a $50,000 vehicle as if it costs $10,000 a year over five years, but the full $50,000 left the company on the day it bought the truck. Subtracting total capex undoes that smoothing and restores the actual cash drain.
Maintenance Versus Growth Capex
The cash flow statement lumps both into a single line, but the distinction changes how you read the result. Maintenance capex keeps existing operations running: replacing a worn-out machine, repairing a roof, refreshing a fleet. Growth capex funds new capacity: a second factory, a new product line, geographic expansion.
Maintenance capex is effectively mandatory. Skip it and the business deteriorates. Growth capex is discretionary. Cancel it and the business keeps running, just without expansion. A negative free cash flow number driven by heavy growth capex says something very different from a negative number driven by expensive-to-maintain equipment. If capex is dragging your result into negative territory, check the management discussion in the 10-K for any split the company has volunteered.
Changes in Net Working Capital
Working capital adjustments capture the cash effect of timing differences in day-to-day operations. The three components you’ll see are accounts receivable, inventory, and accounts payable, all in the operating activities section under changes in operating assets and liabilities.
- If accounts receivable went up, revenue was booked but not collected. Subtract the increase from your running total.
- If inventory went up, cash bought or built product that hasn’t sold yet. Subtract the increase.
- If accounts payable went up, the company received goods or services it hasn’t paid for. Add the increase back.
Signs are where spreadsheets go wrong. Increases in current operating assets reduce cash. Increases in current operating liabilities preserve it. A fast-growing company that extends generous customer terms can show strong EBITDA while cash disappears into receivables. A company that negotiates longer payment terms with suppliers effectively borrows from vendors and boosts cash without any new revenue. The net swing across all three lines can be substantial.
Levered or Unlevered
Running the formula exactly as laid out above gives you levered free cash flow: what’s left for equity holders after every obligation, including debt service, has been paid. That’s the version you want if the question is how much cash the company can actually distribute or reinvest.
Unlevered free cash flow skips the interest subtraction entirely and uses a hypothetical tax bill calculated as if the company had no interest deduction. It measures cash generated before any payments to lenders. That’s what most discounted cash flow models want, because they discount at the weighted average cost of capital and would double-count the cost of debt if interest had already been subtracted upstream.
Pick one and be consistent. For debt coverage questions, use levered. For enterprise valuation, use unlevered. Mixing them produces a valuation that is meaningfully wrong.
Non-Cash Items That Sit in Between
The four-step formula handles the major adjustments. Three other items commonly muddy the bridge and deserve attention.
Stock-Based Compensation
Stock-based compensation is an operating expense, but no cash leaves the company when it issues options or restricted shares. Many companies add it back in their “adjusted EBITDA,” which effectively treats it as a free item. It isn’t free: it dilutes existing shareholders just as if the company had paid cash bonuses and sold new shares at the same time. The conservative approach is to leave it as an expense in free cash flow rather than add it back, even though many Wall Street models do the opposite. At minimum, know what the adjusted EBITDA figure you started from has already excluded.
Impairments and Restructuring
Asset impairments and goodwill write-offs are non-cash, and adjusted EBITDA typically strips them out. Nothing further to do for the non-cash portion. Restructuring charges are trickier: they often mix real cash costs like severance, lease termination fees, and relocation expenses with non-cash write-offs. Check the footnotes for the cash portion and make sure it’s captured somewhere in your calculation.
Leases Under ASC 842
Lease classification changes where the cash payment appears. Operating lease payments run through operating expenses, so they reduce EBITDA. Finance lease payments get split, with the interest portion in interest expense and the principal portion in financing activities, so they don’t reduce EBITDA at all. Two companies with identical economics but different lease structures can report different EBITDA figures. If you’re comparing companies or benchmarking conversion rates, check lease reliance and classification.
Reading the Result
A positive free cash flow number is cash the business genuinely has available after operations, taxes, debt service, and capital investment. It can pay down debt, buy back shares, fund acquisitions, or pay dividends without borrowing or issuing equity. Negative free cash flow means cash went out faster than it came in, which is not automatically a problem for a company investing heavily in growth capacity.
The ratio of free cash flow to EBITDA is often more informative than either number alone. A business converting 60–70% of EBITDA to free cash flow is capital-light and efficient. One converting 10–20% is capital-heavy, tax-burdened, or carrying expensive debt. A company can report impressive EBITDA growth while its free cash flow stagnates, and that gap is one of the clearest signs that the headline number isn’t the whole story.
Where the Calculation Shows Up in Contracts
This isn’t only an analytical exercise. Loan agreements build covenants around EBITDA-based cash flow ratios: leverage ratios (total funded debt over EBITDA) and fixed charge coverage ratios (EBITDA less certain cash expenses, over interest and scheduled principal). Breaching a covenant can trigger a default, accelerate repayment, or block new borrowing.
Credit agreements also use free cash flow to limit shareholder distributions. Restricted payments covenants typically cap dividends and buybacks, often through a “builder basket” that accumulates from excess free cash flow over time. If free cash flow falls, the basket stops growing and the company loses the legal room to return capital even when other cash is available.
One tax rule worth flagging: the Section 163(j) limitation on business interest deductions now allows companies to add back depreciation, amortization, and depletion when calculating the income base that determines deductibility.1Internal Revenue Service. Questions and Answers About the Limitation on the Deduction for Business Interest Expense Deductible interest is generally capped at 30% of that adjusted figure.2eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited For capital-intensive borrowers with large depreciation charges, restoring the EBITDA-based calculation raises deductible interest, lowers cash taxes, and lifts free cash flow. When you’re modeling a leveraged business, that interaction is where the tax rules feed directly back into the number you just built.