By Compounding Academy
This is the next issue in our What Makes a Quality Business miniseries. Today, we focus on two foundational – and often overlooked – ingredients of a resilient compounder: Free Cash Flow and Balance Sheet Strength.
These are more than just accounting line items. They’re signals. They tell you whether a company can self-fund growth, return capital to shareholders, and survive – or better still thrive – through downturns.
Many investors focus mainly on revenue or earnings. But durable compounding depends on two deeper signals: how much cash the business keeps, and how much cushion it has.
Free cash flow (FCF) is the surplus cash left after a company pays for operations and reinvests to maintain its business. It’s what fuels:
• Dividends and buybacks
• Acquisitions and innovation
• Financial flexibility when markets turn
High and consistent FCF is a sign of quality. It means the business is not just growing – it’s growing profitably.
Balance sheet strength is what allows a company to stay in control. When capital markets dry up or the cycle turns, strong balance sheets buy time — and sometimes opportunity to thrive.
At Compounding Academy, we typically look for:
• FCF conversion of at least 80% of net income — ideally 100%+
• Net debt-to-EBITDA below 2x — or better yet, a net cash position
These traits suggest the company can:
• Turn profits into real, usable cash
• Reinvest and return capital without stretching
• Navigate uncertainty without relying on external financing
When you find a business that meets both thresholds consistently, you’ve likely found one that can compound — on its own terms.
Watsco is the largest distributor of HVAC equipment in North America. On the surface, it’s a distributor, not the kind of company that usually makes headlines. But beneath the surface, it’s a cash machine.
• FCF Conversion: Consistently exceeds 100% of net income. This tells you the earnings are real and cash-backed.
• Balance Sheet: Net debt is minimal. This gives Watsco the firepower to make acquisitions, pay dividends, and navigate slowdowns without financial strain.
• Capital Allocation: Over 80% of cash flow goes to dividends — but there’s still room to fund growth through bolt-on M&A.
Its business model — focused on HVAC replacement demand — is low volatility, capital-light, and built to throw off cash year after year. That’s compounding in action.
The chart below shows why Watsco stands out. It has consistently converted earnings into free cash flow, often above 100% — and has done so with very little leverage. That combination of cash-generating power and balance sheet discipline is what enables long-term compounding.
Carnival is a reminder that moderate debt is only safe when earnings are stable. In cyclical, capital-intensive industries like cruise lines, a sudden collapse in EBITDA can expose a fragile foundation. That’s exactly what happened in 2020 — when operations halted due to the pandemic, free cash flow plunged deep into the red, and leverage spiked.
• FCF Conversion: When cash generation evaporates, FCF conversion becomes meaningless, and concerning. Carnival’s conversion ratio turned sharply negative, highlighting the unsustainability of its cost structure during downturns.
• Balance Sheet: Net debt surged past 8x EBITDA at the worst point. Even now, years later, leverage remains elevated, limiting financial flexibility and shareholder returns.
• Lesson: Don’t just look at today’s debt ratio, look at how volatile EBITDA is. A seemingly manageable balance sheet can become a burden when the cycle turns.
The chart below makes the story clear. Even though traditional ratios break down when earnings go negative, the magnitude of the drop-off speaks for itself.
Note: Negative EBITDA and FCF during this period render traditional ratios like Net Debt/EBITDA and FCF Conversion not meaningful. They are included here to show the severity of financial stress.
• Free cash flow is the fuel of compounding. Look for companies that consistently convert earnings into cash, ideally 100% or more of net income.
• A strong balance sheet gives companies options. Net Debt to EBITDA below 2x is a good benchmark for financial flexibility.
• Earnings mean less if they can’t be reinvested. High debt or low cash flow ties a company’s hands, especially in a downturn.
• Context matters. In cyclical or capital-intensive industries, even moderate leverage can become dangerous when EBITDA collapses.
• Ratios are only meaningful when the inputs are. When EBITDA or FCF turns negative, traditional metrics break down, but the size of the drop still tells a story.
Now it’s your turn. Take 3 companies in your portfolio — or on your watchlist — and ask:
1. Does this business consistently convert earnings into free cash flow?
2. What percentage of net income becomes real, usable cash?
3. Is the balance sheet strong enough to weather a downturn?
Look for companies that convert at least 80% of net income into FCF, ideally over 100%, and maintain Net Debt to EBITDA below 2x. These are signs of discipline, resilience, and the ability to compound over time.
Explore our one-pagers to see how high-quality companies like Watsco demonstrate these traits in real life, and how they compare to more fragile businesses like Carnival.
You’ll find 50+ one-pagers and business quality assessments with:
• FCF conversion charts across 15 years
• Key debt metrics across 15 years
• Quality scoring based on our compounding framework
Visit compounding-academy.com to explore the library.
Next up in our What Makes a Quality Business series:
Discussing the right mindset as the foundation for successful long-term investing.