What Is Free Cash Flow (FCF)?Definition, Formula, Examples

Free cash flow is the metric that ultimately determines a business's ability to service acquisition debt. When a buyer finances a purchase through an SBA loan or seller financing, the lender evaluates whether the projected FCF covers the annual debt payments with an adequate margin of safety. A business with strong EBITDA but low FCF due to heavy capital requirements may not support the debt load needed to complete the acquisition at the asking price.

In the discounted cash flow method, projected free cash flows for five to ten years are discounted to present value using a rate that reflects the risk of the business. This approach is particularly useful for businesses with strong growth trajectories, unique competitive advantages, or cash flow profiles that differ significantly from industry averages. Unlike multiple-based valuations, DCF captures the specific financial dynamics of the individual business rather than relying on broad industry benchmarks.

Tracking free cash flow over time reveals whether a business is truly generating value or simply maintaining the appearance of profitability through accounting methods. A business that consistently converts 70% or more of its EBITDA into free cash flow demonstrates operational efficiency and low capital intensity, both of which attract premium valuations from buyers seeking businesses that generate distributable cash from day one.