Free cash flow is what institutional capital actually pays for. EBITDA is the headline an operator brings to the table, but the price is set on how much of that EBITDA converts to cash the business can keep. Across the $20M to $100M operator tier, free cash flow converts at 35 to 75 percent of EBITDA, and the spread inside that range is the difference between a multiple that expands and one that compresses.
This guide walks the free cash flow calculation, the institutional methodology behind it, and the six operator errors that obscure the cash truth a buyer, a lender, and a sponsor each read in their own way. The conversion rate is not a footnote. It is the number that prices the business.
Free cash flow equals operating cash flow minus maintenance capex minus cash taxes. Operating cash flow is net income plus non-cash charges adjusted for the change in working capital. Maintenance capex is the spend required to sustain the current asset base, and it is deducted because it is the cost of keeping the business running at its present capacity. Cash taxes are what the business actually pays, not the book provision. Growth capex is treated separately and analyzed against the return on capital it is expected to produce, so a year of heavy expansion does not read as a cash-poor year. The result is the cash the business generates and can keep, and it is the figure institutional capital prices against. EBITDA is where the conversation starts. Free cash flow is where it settles.
Free cash flow is the base number. Its margin places the operator against the sector, and its yield places the business against the price paid for it. Select a metric to see the formula, what it reads, and why each one matters to a different counterparty.
Operating Cash Flow minus Maintenance Capex minus Cash Taxes
The cash the business produces after sustaining its current asset base and settling its real tax obligation. It is the number institutional capital actually pays for.
Free cash flow is the cash truth behind the EBITDA headline. A business that reports strong EBITDA but converts poorly is priced on what it converts, not on what it reports.
Operating cash flow is net income plus non-cash charges adjusted for the change in working capital. The non-cash charges are the items that reduced reported earnings without leaving the business, principally depreciation and amortization. The working capital change is the cash the business absorbed or released as receivables, inventory, and payables moved. A growing business funds its own growth through working capital, so the change is usually a use of cash that pulls operating cash flow below net income plus non-cash charges.
Take a business with $4.2M of net income. Add $3.1M of non-cash charges and the figure is $7.3M. A $0.9M build in receivables and inventory, net of payables, is a use of cash that reduces the result to $6.4M of operating cash flow. That $0.9M is the cost of growth the income statement never shows, and it is exactly where the cash truth begins to separate from the EBITDA headline.
Reported earnings after interest, taxes, depreciation, and amortization for the trailing twelve months.
Depreciation and amortization of $2.8M plus stock-based and other non-cash items of $0.3M added back.
A $0.9M build in receivables and inventory net of payables, a use of cash that reduces the result.
Net income plus non-cash charges adjusted for the working capital change, the starting point for free cash flow.
The institutional methodology for free cash flow, from operating cash flow through maintenance capex, the growth capex split, working capital normalization, and a documented bridge.
Begin from net income, add back non-cash charges, and adjust for working capital changes to reach operating cash flow.
Deduct the capital expenditure required to sustain the current asset base.
Hold growth capex out of the core calculation and analyze it against the return on capital it is expected to produce.
Normalize for seasonal or one-time working capital swings so the result reflects sustainable cash generation.
Build the bridge from EBITDA to free cash flow so the conversion rate is transparent in diligence.
The capex split is where most free cash flow calculations break. Maintenance capex is deducted inside free cash flow. Growth capex is held out and analyzed against the return it produces. The line between them is read directly from the asset register and the capex detail, and the place an operator draws it moves the conversion rate the multiple is set on.
The spend required to keep the current asset base running at its present capacity. Replacement equipment, routine refurbishment, and software renewals. Deducted inside free cash flow because it is the cost of standing still.
The spend that adds capacity, opens a location, or builds a new line. Held out of the core calculation and analyzed against the return on capital it is expected to produce, so a high growth year does not read as a cash-poor year.
Operators routinely classify growth capex as maintenance, understating free cash flow, or classify maintenance as growth, overstating it. Acquirers rebuild the split from asset registers and capex detail, and the difference moves the conversion rate the multiple is set on.
The diligence implication is concrete. An operator who runs $1.5M of total capex through the maintenance line, when $0.9M of it opened a new facility, understates free cash flow by the $0.9M an acquirer will recover when it rebuilds the split. The discipline is to evidence the classification before diligence does it, the same standard the Cash Visibility Maturity Model reads against.
FCF margin is free cash flow divided by revenue. It measures how much of each revenue dollar reaches free cash flow, and it is read against sector benchmarks rather than in isolation. A 12 percent FCF margin is strong in distribution and ordinary in professional services. The benchmarks below are directional bands for the $20M to $100M tier.
| Sector | FCF Margin Band | What Sets It |
|---|---|---|
| Distribution and logistics | 4 to 8 percent | Working-capital-heavy and capex-light. Margin is read against inventory turns and receivable discipline. |
| Light manufacturing | 7 to 12 percent | Maintenance capex on the plant is the swing factor. Aging equipment compresses the margin quietly. |
| Business and professional services | 12 to 20 percent | Asset-light with low capex. The drag, if any, sits in receivables and deferred billing. |
| Healthcare services | 8 to 15 percent | Payor mix and collection cycles drive the working capital swing that sets the margin. |
FCF yield is free cash flow divided by enterprise value. It expresses the cash return the business produces relative to the price paid for it, and it is the metric sponsors use to model returns. A business with $6.4M of operating cash flow, $1.2M of maintenance capex, and $1.0M of cash taxes produces $4.2M of free cash flow. At a $42M enterprise value, that is a 10 percent FCF yield. At a $60M enterprise value, the same cash produces a 7 percent yield, and the structure has to make up the difference through growth or leverage to clear the return hurdle.
Lenders read FCF yield as the cushion behind debt service, and sponsors read it as the entry point for return modeling. A high entry multiple on a low FCF yield is the structure that compresses returns through the hold, which is why the yield is computed before the price is agreed, not after. The Lender Readiness Check reads coverage against the same free cash flow figure, and the EBITDA gap upstream of it is modeled in the EBITDA Quality Calculator.
Each error moves the conversion rate, and each is recoverable by an acquirer or a lender who rebuilds the number. The valuation impact bands below are directional for the $20M to $100M tier.
Treating EBITDA as cash and skipping the working capital change overstates free cash flow by 5 to 15 percent on a growing business that funds its own receivables and inventory.
Loading growth spend into the maintenance line understates free cash flow by 10 to 25 percent and hands diligence a recovery the buyer keeps.
Free cash flow runs on cash taxes paid, not the book provision. The gap from deferred items and NOLs moves the result 8 to 18 percent.
A single large customer prepayment or asset sale read into recurring free cash flow distorts the conversion rate and the run-rate the multiple is applied to.
Treating capital leases as off the cash statement understates the real claim on cash and leaves the lender reading less coverage than the operator presents.
Calculating free cash flow off a single quarter rather than a normalized year over- or understates conversion by 6 to 12 percent depending on which part of the cycle the period captures.
A free cash flow number is only as good as its behavior under pressure. The Capital Structure Stress Test reads how the conversion rate holds when revenue contracts, when working capital tightens, and when maintenance capex cannot be deferred. It is the difference between free cash flow that is real and free cash flow that depends on a single benign year. A business that converts at 60 percent in a good year but cannot service its structure when conversion falls to 40 percent does not have a 60 percent number. It has a 40 percent number with a good year attached.
The discipline behind a defensible free cash flow figure is cash visibility. The five stages of the Cash Visibility Maturity Model describe how an operator moves from a reactive view of cash to an institutional one, and the framework itself places a business on that ladder. The terms underneath, free cash flow, operating cash flow, conversion, and the capex split, are defined precisely in the TEOL Glossary. Free cash flow is not a number an operator reports. It is a number a counterparty rebuilds, and the operators who rebuild it first negotiate from the cash truth rather than from the EBITDA headline. Begin in the Operating Library.
EBITDA opens the conversation. Free cash flow settles it. Rebuild the conversion rate before a buyer, a lender, or a sponsor does it for you, then negotiate from the cash truth.