Free Cash Flow for Business Owners: The Formula Buyers and Lenders Use
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Say a firm booked $520,000 of profit last year and the owner could only use about $170,000 of it. Free cash flow is the measure that explains where the rest went:
Free cash flow = Cash flow from operating activities − Capital expenditures
That's the free cash flow formula in its standard form. It tells you how much cash the business produced after keeping its equipment, software, and facilities in working order. The catch is that there's no single official version. The SEC's own staff guidance on non-GAAP measures says free cash flow "does not have a uniform definition" and warns against implying it's cash available for discretionary spending when debt service and other mandatory payments haven't been deducted.
So when a buyer, a lender, and your CPA each quote you a free cash flow number, they may all be right and all be different. This article works the three versions that matter to an owner of a $2M-$20M service business, plus a fourth for pass-through owners, on the same hypothetical firm.
Why owners should care about a number designed for other people
Free cash flow is the number a buyer prices, a lender underwrites, and you live on. Net income can rise while all three of those people get less comfortable, because receivables, equipment purchases, and debt payments don't run through the P&L the way cash does.
If you've worked through Bennett's retained earnings vs. cash bridge, you've already seen the gap across five years. Free cash flow measures the same gap one year at a time.
The three versions, side by side
| Version | Formula | Who uses it | What it answers |
|---|---|---|---|
| Standard (levered) FCF | Operating cash flow − Capex | Owners, analysts | How much cash did operations produce after reinvestment? |
| Unlevered FCF | EBITDA − Cash taxes − Capex − Increase in net working capital | Buyers, valuation | What would this business generate for any owner, before financing? |
| Cash available after debt service | Operating cash flow − Capex − Debt principal | Lenders, owners | After paying the bank, what's left? |
A fourth version is specific to pass-through owners: subtract the distributions you take to cover your personal tax on the business's profit. That's the honest "what can I actually spend or reinvest?" number.
One hypothetical firm, four answers
This example is hypothetical: a $5M-revenue IT services firm, S corporation, accrual books.
Starting figures for the year
| Item | Amount |
|---|---|
| Net income | $520,000 |
| Depreciation and amortization | $60,000 |
| Interest expense | $40,000 |
| EBITDA (pass-through, no entity income tax) | $620,000 |
| Increase in accounts receivable | ($90,000) |
| Increase in accrued liabilities and payables | $20,000 |
| Capital expenditures (laptops, servers, office fit-out) | ($70,000) |
| Loan principal paid | ($120,000) |
| Owner distributions for personal tax on firm profit | ($150,000) |
Version 1: Standard free cash flow
Operating cash flow starts from net income, adds back non-cash expenses, and adjusts for working capital:
Operating cash flow = $520,000 + $60,000 − $90,000 + $20,000 = $510,000
Free cash flow = $510,000 − $70,000 = $440,000
Interest is already inside operating cash flow here, because it reduced net income.
Version 2: Unlevered free cash flow (the buyer's view)
A buyer wants a number that doesn't depend on how you financed the company, so they start from EBITDA. Because an S corporation doesn't pay entity-level income tax, a buyer typically applies an assumed tax charge to make the cash flow comparable to a taxed entity. Assume the buyer uses $150,000 in this illustration.
Unlevered FCF = $620,000 − $150,000 (assumed taxes) − $70,000 (capex) − $70,000 (net working capital increase) = $330,000
The net working capital line is $90,000 more receivables minus $20,000 more payables. Buyers watch that line closely: a firm that has to fund growing receivables every year is worth less per dollar of EBITDA than one that collects quickly. It's also where many quality-of-earnings reviews find surprises, which is why Bennett's piece on quality of earnings spends so much time there.
Version 3: Cash after debt service (the lender's view)
Cash after debt service = $440,000 − $120,000 (principal) = $320,000
A lender would usually turn this into a ratio, comparing cash available for debt service against principal and interest. The debt service coverage ratio guide covers that calculation and how lenders define the inputs.
Version 4: Owner's discretionary cash
Owner's discretionary cash = $320,000 − $150,000 (tax distributions) = $170,000
That's the number that funds a bonus pool, a new hire, a reserve top-up, or a further distribution. It's about a third of net income. Most owners, looking at a $520,000 profit, would guess higher.
Why four answers from one set of books
The four results range from $440,000 to $170,000. None is wrong. Each audience removes the costs that matter to its own claim on the cash:
- The standard version keeps financing inside the number, because it's built from your actual operating cash flow.
- The buyer strips out your financing, then charges a notional tax, because the buyer will finance and structure the deal its own way.
- The lender subtracts the principal it's already owed before asking whether you can carry more.
- The owner subtracts the tax that the business's profit creates on your personal return.
Bring the right version to the right meeting. Quoting a buyer your standard free cash flow invites them to re-cut it, and they'll do it with their assumptions, not yours. Quoting a lender a number before principal invites the question of why you left out the debt they're already carrying.
If your free cash flow is running well below net income and you can't say why, start with receivables, capex, and debt timing. A Profit & Tax Leak Check points to which of the three is absorbing cash in your business.
The ratio that tells you whether growth is costing you cash
Once you have free cash flow, divide it by EBITDA:
Free cash flow conversion = Free cash flow ÷ EBITDA
For the hypothetical firm: $440,000 ÷ $620,000 = about 71%.
Don't fixate on the level. Watch the trend. If EBITDA is growing and conversion is falling, the business is spending more of each dollar of earnings on receivables or equipment to grow. That isn't automatically bad. It's a choice, and you should know you're making it.
| Year | EBITDA | Free cash flow | Conversion |
|---|---|---|---|
| Year 1 (hypothetical) | $480,000 | $380,000 | 79% |
| Year 2 | $550,000 | $400,000 | 73% |
| Year 3 | $620,000 | $440,000 | 71% |
EBITDA grew 29% over two years in this illustration. Free cash flow grew 16%. The difference went into working capital and equipment.
Mistakes that distort free cash flow
Treating every equipment purchase as capex and every software subscription as operating. Be consistent year to year. A buyer will reclassify if you aren't.
Ignoring capitalized software or leasehold improvements. These are capital spending even if they don't feel like it.
Forgetting financed equipment. If a vendor finances a server purchase, the capex still happened. Record it, along with the new debt.
Using cash-basis books. On cash basis, the working capital line disappears and free cash flow looks the same as cash in minus cash out. You lose the early warning that receivables are building. Bennett's look at operating cash flow margin explains why accrual-based operating cash flow is the better starting point.
Reading one year in isolation. A single year of heavy capex can make free cash flow look weak. Compare a three-year average.
What to do with the number
Free cash flow should drive three decisions: how much you can distribute without starving the business, how much debt the business can carry, and how a buyer will see value. If those decisions are being made from net income today, they're being made from the wrong number.
That's a core part of what a fractional CFO builds: a monthly cash flow statement that produces all four versions above automatically, so you aren't reconstructing them the week a lender or buyer asks. For the mechanics of building the statement itself, see how to calculate cash flow.
Run Version 1 on last year's numbers this week: operating cash flow from your cash flow statement, minus everything you bought that's on the balance sheet as an asset. Then divide by EBITDA. If conversion is below where it was two years ago, find out which working capital line moved, and use a Leak Check to see whether that line is a growth investment or a leak.
Frequently asked questions
Is free cash flow the same as EBITDA?
No. EBITDA ignores working capital, capital spending, and taxes. Free cash flow subtracts them, so it's usually lower and closer to the cash the business actually produced.
Can free cash flow be negative in a healthy business?
Yes, in a year of heavy investment or fast growth that ties up cash in receivables. It becomes a concern when it stays negative without a planned reason or funding source.
Do buyers use free cash flow or EBITDA to value a service business?
Many quote a multiple of EBITDA, then adjust the price for working capital, capex needs, and debt-like items. Free cash flow is what those adjustments are protecting.
Are owner distributions subtracted from free cash flow?
Not in the standard definition. Distributions are a use of free cash flow. For pass-through owners, subtracting tax distributions gives a more realistic picture of discretionary cash.
Where do I find capital expenditures if I don't have a cash flow statement?
Compare fixed assets on two balance sheets and add back the year's depreciation. The result approximates capex, though disposals and financed purchases need adjusting.
Does leasing equipment instead of buying it increase free cash flow?
It shifts the cost from capex into operating payments, which can raise reported free cash flow. Buyers and lenders often adjust for this, so compare total cost rather than chasing a better FCF figure.
Can a company report free cash flow per share?
SEC staff guidance says free cash flow is a liquidity measure that must not be presented on a per share basis in SEC filings. For a private owner this matters little, but it shows the measure is about cash, not earnings.
How often should a small business calculate free cash flow?
Monthly or quarterly on a trailing twelve-month basis. A single month is too noisy because capex and tax payments are lumpy.