The cash a company generates after covering operating expenses and maintenance capital expenditures, available for shareholder returns, debt repayment, or reinvestment in growth.
EBITDA is the reigning metric in M&A conversations, but there is a more important measure that many inexperienced buyers overlook: free cash flow. A company can have an excellent EBITDA and generate no cash — if it must constantly reinvest in machinery, if customers pay at 120 days, or if it accumulates inventory that never sells. Free cash flow is the unvarnished truth about a company’s ability to produce real money — money that can be distributed as dividends, used to repay debt, or reinvested in growth.
Free cash flow (FCF) is the cash a company generates in a given period after meeting all its operating expenses and the capital expenditure required to maintain its productive capacity. It is the money genuinely available for the providers of capital (shareholders and lenders).
The most widely used formula is:
FCF = EBITDA - Operating taxes - Change in working capital - Maintenance capex
Breaking down each component:
A second variant exists — free cash flow to equity (FCFE) — which further deducts debt service (interest plus principal repayment). FCFE represents the cash available specifically to shareholders.
EBITDA is useful as a comparison metric and a starting point for valuation, but it has significant limitations that FCF corrects:
EBITDA ignores investment needs. An industrial company with an EBITDA of 3 million that must invest 2 million annually in machinery maintenance generates an FCF of only 1 million. A services company with the same EBITDA but negligible capex generates 3 million of FCF. The real value of both businesses is very different, even though their EBITDA is identical.
EBITDA ignores working capital. A fast-growing company can have rising EBITDA while consuming cash at an unsustainable rate, because it needs to finance more inventory and more receivables. FCF captures this effect.
EBITDA ignores taxes. Two companies with the same EBITDA but different effective tax rates (due to differences in fiscal structure, accumulated tax losses, or special regimes) generate different cash flows.
The discounted cash flow method (DCF) is the theoretically most rigorous approach to valuing a company, and its raw material is precisely projected future free cash flows.
The logic of DCF is: a company is worth today the sum of all the free cash flows it will generate in the future, discounted at a rate that reflects the risk of receiving them. Year 1 FCF is worth more than year 10 FCF (due to the time value of money), and a stable company’s cash flows are worth more than a volatile company’s (due to risk).
In mid-market practice, DCF is used as a complement to (not a substitute for) multiple-based valuation. Multiples provide a quick range; DCF verifies whether that range makes sense from the perspective of actual cash generation.
When Blue Mountain analyses a company, FCF reveals patterns that EBITDA conceals:
FCF consistently below EBITDA. This indicates the business requires heavy investment to maintain its activity level (capital-intensive business) or has an unfavourable working capital cycle. Not necessarily bad, but the valuation multiple must reflect this reality.
Negative FCF with positive EBITDA. A serious red flag. Possible causes: overinvestment (excessive capex), deteriorating working capital (customers not paying, inventory accumulating), or EBITDA inflated by accounting adjustments that do not translate into real cash.
Volatile FCF. If FCF swings dramatically from year to year without a clear explanation (known seasonality, documented investment cycle), it signals prediction risk that should be reflected in the discount rate or the valuation multiple.
Growing FCF with stable EBITDA. A positive signal. It indicates the company is improving its operational efficiency: collecting faster, managing inventory better, reducing investment needs. It is an indicator of good management.
Blue Mountain compares two companies as acquisition candidates:
Company A (metal components manufacturer):
Company B (technical consulting services):
Company B has EBITDA that is 500,000 euros lower, but it generates nearly double the free cash flow. If both are valued at the same EBITDA multiple, the buyer of Company A is paying more for each euro of cash actually received. An analysis based solely on EBITDA would lead to an erroneous conclusion. FCF reveals the truth.
No. “Cash flow” is a generic term that can refer to different measures (operating cash flow, investing cash flow, financing cash flow). Free cash flow is a specific measure that isolates the cash available to reward capital providers after covering operations and maintenance investment. It is a more refined and more useful metric for valuation.
It is one of the most important — and most difficult — questions in financial due diligence. Maintenance capex is what is needed for the company to continue operating at its current level (replacing worn equipment, renewing licences, maintaining facilities). Growth capex is intended to expand capacity (new factory, new product lines, geographic expansion). Companies do not always distinguish between the two in their accounting, so the buyer must analyse investments line by line.
DCF based on FCF is a complete valuation method, but it requires long-term financial projections and a well-substantiated discount rate. Small changes in these assumptions can significantly alter the result. That is why, in practice, it is used as a complement to market multiples: multiples provide a range, and DCF confirms whether that range is consistent with the business’s actual cash generation capacity.
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