Maximize Value, Minimize Risk: Essential Cash Flow Metrics for Smarter Deal-Making
Why Do These Metrics Matter in Today’s Deal-Making Landscape?
In the current environment of rising interest rates and tightening credit markets, simply evaluating profitability is no longer sufficient. Lenders, buyers, and investors are demanding deeper insights into a company’s actual cash flow and its ability to meet financial obligations. For lower middle market deal-makers, cash flow metrics like Free Cash Flow (FCF) and Cash Available for Debt Service (CADS) are not just advantageous—they are vital.
While General Partners (GPs) still have access to capital, they are deploying it more cautiously due to heightened scrutiny around deal structures. Lenders, in particular, are far less forgiving when it comes to gaps in cash flow analysis. By focusing on FCF and CADS, deal-makers can gain a much more accurate and holistic view of a business’s financial health. These metrics are critical for assessing whether a company can sustain operations, manage debt loads, and weather potential economic challenges. In today’s market, where credit is more expensive and access to capital is tighter, it’s essential to ensure that businesses have sufficient cash flow to support their debt obligations while also allowing room for growth.
Free Cash Flow (FCF) and Cash Available for Debt Service (CADS) offer critical insights into whether a business can maintain growth, meet debt obligations, and manage operational risk. EBITDA, while useful for measuring operational performance, falls short in reflecting the actual cash available for reinvestment or debt repayment once essential operating and capital expenses are factored in. As financial scrutiny intensifies, these metrics have become essential tools for ensuring the long-term sustainability and success of any transaction.
Free Cash Flow (FCF)
Free Cash Flow (FCF) shows how much actual cash the business generates after covering its operating expenses, taxes, and necessary investments like equipment or upgrades (capital expenditures). It represents the cash that’s truly available to the business for growth, paying dividends, reducing debt, or handling unexpected costs.
Why FCF matters: It provides a much clearer picture of the company’s financial health compared to EBITDA because FCF accounts for all essential expenses. If a company has strong FCF, it means it has real flexibility to use that cash however it needs, whether for reinvestment, acquisitions, or returning value to shareholders.
Cash Available for Debt Service (CADS)
Cash Available for Debt Service (CADS) focuses specifically on the cash available to pay off debt, which is essential if you’re taking on a loan to finance an acquisition. It measures the business’s ability to cover both interest and principal payments on its debt after all operating costs have been paid.
Why CADS matters: If the business doesn’t have sufficient CADS, it won’t be able to meet its debt obligations, even if it looks profitable based on EBITDA. In the case of loans, especially SBA loans, lenders will closely monitor CADS to ensure there’s enough cash flow to comfortably make debt payments without putting the business at risk. This is crucial as interest rates rise, making borrowing more expensive.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
EBITDA is a measure of a business’s profitability from its core operations. It shows how much the company earns before factoring in costs like interest payments, taxes, and non-cash items such as depreciation and amortization.
Why EBITDA matters: While useful for understanding a company’s operational performance and for calculating valuation, EBITDA doesn’t tell you how much cash is actually available to pay debts or reinvest in the business. It ignores key expenses like capital expenditures and taxes, making it less useful in determining a company’s true cash flow, particularly in debt-heavy acquisitions
In Summary
- FCF shows how much cash is truly left after covering all essential expenses and investments. It’s the most accurate measure of how much money is available to the business for growth or other uses.
- CADS tells you whether the business can handle its debt payments. It’s crucial for any acquisition involving loans, as it shows whether the business can meet its financial obligations comfortably.
- EBITDA is a good indicator of operational performance, but it doesn’t account for cash needed to pay debts or reinvest in the business.
In any deal, EBITDA helps you understand a company’s profitability, but FCF and CADS give you a true sense of its financial health and ability to grow or handle debt.
Final Take
For lower middle market deal-makers, these cash flow metrics are just a strategic advantage—it’s an absolute necessity. While LPs may still have access to capital, they are deploying it more cautiously, and deals are facing more rigorous scrutiny than ever. Lenders, in particular, are less forgiving of gaps in cash flow analysis. By focusing on Free Cash Flow (FCF) and Cash Available for Debt Service (CADS), deal-makers can gain a clearer, more accurate understanding of a business’s financial strength, setting themselves up for smarter, more sustainable deals in this challenging environment.
For Fund Managers, the pressure isn’t just on identifying great assets but also on ensuring those investments can endure economic uncertainty. With leverage becoming more expensive and harder to secure, CADS is essential for evaluating a company’s ability to manage its debt load. At the same time, FCF provides confidence that portfolio companies generate enough cash to fuel growth or make essential operational improvements post-acquisition.
Future Outlook
As we look toward 2025, the economic landscape will continue to shift, with potential fluctuations in interest rates, inflation, and credit conditions. However, the need for deeper financial insights and a focus on cash flow metrics will remain constant. Deal-makers who prioritize FCF and CADS will be better equipped to navigate the uncertainties, make more informed decisions, and build long-term value. In this environment, understanding and mastering these metrics will be the key to thriving, not just surviving, in the evolving market.
