Free cash flow (FCF) is operating cash flow minus capital expenditures. It's the cash available to service debt, pay owners, or reinvest after maintaining and growing the business's asset base. FCF is the most common numerator for DSCR calculations at the bank lending tier.
Free cash flow is the purest measure of financial health because it shows the cash a business actually generates after everything required to keep it running — including reinvestment in assets. Formula: FCF = Operating Cash Flow - Capital Expenditures (CAPEX). Why FCF matters for lending: DSCR (Debt Service Coverage Ratio) is most robustly calculated as FCF / Total Annual Debt Service. This is the metric bank lenders use to determine how comfortably a business can service new debt. A business with $500K FCF and $300K in annual debt service has a DSCR of 1.67x — comfortable for most bank lenders. The same business with $200K FCF and $300K debt service has a DSCR of 0.67x — the cash flow doesn't cover the debt. For fast-growing businesses, FCF can be negative even with strong revenue and profits — because growth requires heavy CAPEX investment (new locations, equipment, technology). This is normal and expected in high-growth phases. Investors fund the FCF gap with equity; lenders provide debt against projected future FCF. The risk: if growth doesn't materialize, the CAPEX spending generates debt service but not FCF. The SBA's standard underwriting framework for 7(a) loans (https://www.sba.gov/funding-programs/loans/7a-loans) requires lenders to demonstrate that FCF is adequate to service proposed debt. The Federal Reserve's Z.1 Financial Accounts (https://www.federalreserve.gov/releases/z1/) tracks aggregate free cash flow metrics across corporate and noncorporate business sectors.
DSCR = FCF / Total Annual Debt Service. Debt service includes all principal and interest payments on existing and proposed debt for the period. Most bank lenders require DSCR of 1.25x or higher (meaning FCF covers debt service with 25% cushion). SBA requires a minimum of 1.15x in most cases. Below 1.0x means the business can't service its debt from operating cash flow alone.
Yes, in theory, if it has large debt maturities (balloon payments) that FCF can't cover in a lump sum even if the annual debt service is manageable — or if the timing of FCF doesn't match debt service due dates. Liquidity crises (running out of cash at a specific moment) and solvency crises (total debt exceeds value) are distinct from FCF adequacy.
Unlevered FCF (UFCF): FCF before debt service — what the business generates from operations before paying any lenders. UFCF is used in enterprise valuation (discounting at WACC). Levered FCF (LFCF): FCF after debt service — what's left for equity owners. For small-business lending, lenders typically work with what's available to service debt — similar to UFCF. For owner distributions, LFCF is the relevant number.