Free cash flow, explained simply
EBITDA is a profit measure and cannot be spent. Free cash flow deducts what the business must reinvest to operate and grow, and so shows whether it can carry the debt used to acquire it. A business with high EBITDA and low free cash flow is riskier than it appears.
Unlevered free cash flow is measured before interest and is used for valuation. Levered free cash flow is measured after interest and shows capacity to repay debt.
From adjusted EBITDA to free cash flow
IllustrativeAlder Creek Manufacturing, FY2025, $ millions
Of $4.6 million of EBITDA, only $1.6 million is free cash flow, mainly because cash was absorbed by receivables.
Calculation
Worked example
| Alder Creek, FY2025, $ millions | Amount |
|---|---|
| Adjusted EBITDA | 4.6 |
| Cash taxes | (0.8) |
| Capital expenditure | (1.0) |
| Increase in net working capital | (1.2) |
| Free cash flow before financing | 1.6 |
| Interest paid | (0.5) |
| Free cash flow after financing | 1.1 |
Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.
Why it matters in a deal
Free cash flow shows whether the business can carry the debt used to buy it, and is the basis of lender covenant analysis.
Red flags
- EBITDA rising while free cash flow falls
- Capital expenditure deferred to improve cash flow before the sale
- Large one-off working capital releases