When deriving Free Cash Flow from EBIT, which sequence is correct?

When deriving Free Cash Flow from EBIT, which sequence is correct?

• A. EBIT, apply tax to obtain NOPAT, add back D&A, subtract Capex, subtract increases in working capital, add decreases in working capital
• B. EBIT, subtract taxes, subtract D&A, add Capex
• C. EBIT, subtract interest, subtract taxes
• D. Revenue minus costs plus depreciation

Answer: (A)

Converting EBIT to Free Cash Flow requires moving from accrual operating income to the cash actually available after sustaining the business. Start with EBIT, apply taxes to get after-tax operating income (NOPAT), since taxes reduce cash from operating activities but EBIT excludes financing costs. Then add back depreciation and amortization, because these are non-cash expenses that reduced reported income but did not use cash. Next, subtract capital expenditures, as money spent to maintain or expand fixed assets is a use of cash. Finally, adjust for changes in working capital: increases in working capital consume cash (subtract), while decreases release cash (add). This gives FCF = NOPAT + D&A − Capex − ΔWC, which aligns with the idea of cash generated by operations after reinvesting in the business and funding its working capital needs. The other options misstate these steps in key ways: they either mishandle taxes, mis-handle non-cash charges like D&A, omit capex, or ignore working capital effects, so they don’t yield true free cash flow from EBIT.

Converting EBIT to Free Cash Flow requires moving from accrual operating income to the cash actually available after sustaining the business. Start with EBIT, apply taxes to get after-tax operating income (NOPAT), since taxes reduce cash from operating activities but EBIT excludes financing costs. Then add back depreciation and amortization, because these are non-cash expenses that reduced reported income but did not use cash. Next, subtract capital expenditures, as money spent to maintain or expand fixed assets is a use of cash. Finally, adjust for changes in working capital: increases in working capital consume cash (subtract), while decreases release cash (add). This gives FCF = NOPAT + D&A − Capex − ΔWC, which aligns with the idea of cash generated by operations after reinvesting in the business and funding its working capital needs.

The other options misstate these steps in key ways: they either mishandle taxes, mis-handle non-cash charges like D&A, omit capex, or ignore working capital effects, so they don’t yield true free cash flow from EBIT.