Free Cash Flow
Free cash flow is the cash a business generates after paying for its operations, its taxes and the investment it needs to keep running — the cash left over for its providers of capital. Unlevered free cash flow is measured before interest and is what a discounted cash flow valuation discounts; levered free cash flow is what remains for shareholders after debt service.
- Also known as
- FCF, Unlevered free cash flow, Levered free cash flow
- Used at
- valuation (discounted cash flow), debt capacity, and the runway calculation of a loss-making company
- Formula (unlevered)
- EBITDA − taxes on operating profit − capital expenditure − increase in working capital
- Differs from EBITDA by
- tax, capex and working capital — the three things EBITDA ignores
- Fintech watch-points
- capitalised development costs, which are capex, and client funds, which are not the company's cash
How free cash flow works in practice
EBITDA says what a business earns before the things it has to pay for; free cash flow says what is left after them. A payments company with €10m of EBITDA that pays €2m of tax, spends €3m a year on engineers whose work is capitalised as software, and needs €1m more working capital as its volume grows has €4m of free cash flow — and that is the number a buyer can borrow against, a lender can be repaid from, and a valuation should rest on.
The gap between EBITDA and free cash flow is where fintech valuations most often go wrong. Development costs capitalised under IAS 38 leave EBITDA untouched and appear as capex; a company that capitalises aggressively shows high EBITDA and low free cash flow, and a buyer that prices it on an EBITDA multiple pays for profit that was never cash. Working capital is the other trap: a lender's loan book, a payments company's settlement float, an e-money institution's safeguarded funds all sit on the balance sheet, and only the first is the company's own investment in working capital.
For a loss-making company free cash flow is the burn rate, and cash divided by burn is the runway — the number every board of a growing fintech watches.
Example
A lending platform reports EBITDA of €8m. Tax on operating profit is €1.6m, capitalised development is €2.4m, and the loan book grew by €5m funded from the company's own cash. Unlevered free cash flow is €8m − €1.6m − €2.4m − €5m = −€1m: a profitable company on the income statement that consumed cash. A buyer valuing it at 12× EBITDA (€96m) is paying for €8m of "profit" that funded a balance sheet; one valuing it on discounted cash flow, with the loan book funded by a warehouse line rather than equity, arrives at €70m.
Common mistakes
- Valuing a company on EBITDA without checking how much of it is capitalised development cost. - Treating growth in a loan book as working capital that the buyer must fund, or as free cash flow that it need not. - Confusing levered and unlevered free cash flow, and discounting the wrong one at the wrong rate. - Counting safeguarded client funds as cash generated. - Reading negative free cash flow as failure in a company that is buying growth deliberately, or as normal in one that is not.