Free Cash Flow (FCF)
Cash generated by a business after operating expenses, taxes, and capital expenditures — the actual cash available for debt service, distributions to owners, or reinvestment. FCF = EBITDA − Taxes − Interest − CapEx − Changes in Working Capital. In M&A, FCF is the economic reality check on EBITDA: a business with $5M EBITDA but $2M of maintenance CapEx and $500K working capital needs generates $2.5M of FCF — meaningfully less than EBITDA implies. DSCR calculations use FCF, not EBITDA.
Full Definition
Free cash flow (FCF) is the cash a business generates from operations after paying for capital expenditures required to maintain and sustain the asset base. It represents the actual cash available to equity and debt holders — the earnings power of the business in cash terms, not accounting terms. In M&A, free cash flow is the true economic measure of business value and the primary driver of a business's ability to service acquisition debt.
The FCF formula: Free Cash Flow = EBITDA − Cash Taxes − Working Capital Changes − Capital Expenditures. Or equivalently: FCF = Net Income + Depreciation/Amortization − Working Capital Increases − Capital Expenditures. The two approaches should produce the same result (with minor timing differences). The key deduction that separates FCF from EBITDA is capital expenditure — the actual cash spent on maintaining and growing the physical asset base.
Why FCF differs from EBITDA: EBITDA adds back depreciation, treating it as a non-cash charge. But depreciation represents the economic consumption of assets — those assets must eventually be replaced, and that replacement costs real cash. In asset-light businesses (software, professional services), the gap between EBITDA and FCF is small because capex requirements are low. In asset-intensive businesses (manufacturing, transportation, real estate), the gap is large — a business with $5M EBITDA and $2M of annual maintenance capex generates only $3M of free cash flow.
FCF yield and valuation: Dividing free cash flow by enterprise value produces the FCF yield — what percentage of the purchase price the business generates in actual cash per year. An acquisition at 6x EBITDA with 70% FCF conversion (FCF is 70% of EBITDA) generates an FCF yield of approximately 11.7% ($FCF/$EV). Comparing FCF yield across acquisition opportunities is a better measure of value than EV/EBITDA alone because it captures capital efficiency.
Levered vs. unlevered FCF: Unlevered free cash flow (before interest payments) is the operating cash flow independent of capital structure — used in DCF analysis to value the enterprise. Levered free cash flow (after interest payments) is the cash available to equity holders after debt service — used to assess equity returns and whether the business can service acquisition debt while remaining a going concern.
Seller vs. Buyer Perspective
Your buyer is thinking about free cash flow whether they say so or not. The FCF they project from your business determines what acquisition debt they can service, and therefore what price they can pay. If your business is capital-intensive, present capital expenditure history clearly — differentiate maintenance capex from growth capex. Maintenance capex is a real cost of sustaining EBITDA; growth capex is discretionary investment. Buyers who confuse the two either overpay (ignoring maintenance capex) or underpay (treating all capex as a permanent drag on earnings power).
Build a normalized FCF model alongside your EBITDA model for every acquisition. Three questions: (1) What is the annual maintenance capex required to sustain current EBITDA — not what was spent last year, but what should be spent? (2) What are the working capital dynamics — does the business require working capital investment as it grows? (3) What is the FCF conversion rate — FCF as a percentage of EBITDA — and how does it compare to industry benchmarks? A business with 90% FCF conversion is worth more than one with 50% conversion at the same EBITDA level.
Real-World Example
A pest control services business has $2M EBITDA on $8M revenue. Annual fleet maintenance capex is $320K; vehicle replacement every 6 years averages $280K/year annualized. Working capital is largely stable (pest control is billed monthly in advance). Cash taxes at an effective 25% rate on pre-tax income of approximately $1.4M = $350K. FCF = $2M − $320K maintenance capex − $280K amortized replacement capex − $350K taxes − minimal WC change = approximately $1.05M. FCF conversion: 52.5% of EBITDA. At a 6x EBITDA purchase price ($12M), the FCF yield is 8.75% — reasonable for a stable, service-based business.
Why It Matters & Common Pitfalls
- !Deferred maintenance creates false FCF. A business that has skipped equipment maintenance for 2–3 years shows elevated free cash flow during the deferral period, followed by catch-up capex that depresses it sharply. Normalize capex to the long-run average, not the recent skimped history.
- !Working capital investment in growth eats FCF. A growing business that requires working capital to fund receivables and inventory may have strong EBITDA and weak FCF. Model the working capital investment required to sustain projected growth rates — this is a real cash cost that reduces free cash flow even as revenue grows.
- !Tax rates matter more than they appear in EBITDA models. EBITDA analysis often ignores cash taxes entirely. But a business paying an effective 30% cash tax rate generates significantly less FCF than one at 15%. Understand the target's tax situation — structure, elections, NOLs, and state taxes — before assuming a standard effective rate.
- !Lease obligations (post-ASC 842) affect FCF calculation. Under ASC 842, operating lease payments are included in operating activities on the cash flow statement, not capital expenditures. Some FCF definitions include lease payments as a deduction (similar to capex); others don't. Be consistent and explicit about your FCF definition when comparing across businesses.
Frequently Asked Questions
What is free cash flow?↓
Why is free cash flow better than EBITDA for valuation?↓
Related Terms
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization — the most common measure of operating profitability used to value businesses in M&A transactions.
CapEx (Maintenance vs Growth)
Capital expenditure on long-lived assets like equipment, vehicles, and facilities — split between **maintenance CapEx** (what's needed to keep the business running at current levels) and **growth CapEx** (what funds expansion).
DSCR (Debt Service Coverage Ratio)
A ratio measuring a business's cash flow available to service debt divided by the annual debt service (principal plus interest) — the primary lending metric for acquisition financing.
Net Working Capital
The capital tied up in a business's operating cycle — typically defined as current assets (AR, inventory) minus current liabilities (AP, accrued expenses), excluding cash and debt — and one of the most negotiated purchase price adjustments.
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Disclaimer: The information provided on this page is for educational and informational purposes only. It should not be considered financial, legal, or investment advice. Business valuations depend on many factors specific to each situation. Always consult with qualified professionals — including business brokers, CPAs, and M&A attorneys — before making acquisition or sale decisions. LegacyVector is not a licensed broker, financial advisor, or attorney. Data shown may be based on limited samples and may not reflect current market conditions.
LegacyVector Research Team
Reviewed by M&A professionals · Updated April 2026