Maximize Value, Minimize Risk: Cash Flow Metrics for Deal-Making

The M&A landscape is increasingly complex, with rising interest rates, inflation, and tighter credit markets reshaping deal structures. As we approach 2025, cash flow stability and debt service capability are under greater scrutiny. Investors, lenders, and buyers demand deeper financial insights beyond revenue and EBITDA, making Free Cash Flow (FCF) and Cash Available for Debt Service (CADS) critical for assessing a company’s financial health and resilience.

Why These Metrics Are Critical in Today’s Deal-Making Environment

With rising capital costs and stricter lending conditions, profitability alone is no longer enough. Investors, lenders, and buyers demand deeper insights into cash flow and financial resilience. For lower middle market deal-makers, FCF and CADS are essential. While General Partners (GPs) still have access to capital, they are deploying it more cautiously, and lenders are less forgiving of cash flow gaps. Prioritizing FCF and CADS provides a clearer view of a business’s ability to sustain operations, manage debt, and withstand economic downturns. In today’s high-cost environment, businesses must maintain strong cash flow to meet obligations while preserving growth potential.

Key Cash Flow Metrics for Smarter Deal-Making

1. Free Cash Flow (FCF): The True Measure of Financial Health

Definition: Free Cash Flow (FCF) represents the cash a business generates after covering its operating expenses, taxes, and capital expenditures (CapEx). It is the best indicator of how much money is actually available for reinvestment, debt repayment, or shareholder returns.

Why FCF Matters:

• Provides a clearer picture of financial flexibility compared to EBITDA, which ignores capital expenditures and other necessary costs.
• Indicates whether a business can self-fund growth, distribute dividends, or reduce debt without relying on external financing.
• Helps investors and lenders assess the sustainability of cash flows and whether a company is operating efficiently.

2. Cash Available for Debt Service (CADS): The Key to Debt Sustainability

Definition: CADS measures the amount of cash available to cover both interest and principal payments on a company’s outstanding debt after all operating costs are paid.

Why CADS Matters:

• Essential for leveraged deals—if a business lacks CADS, it may struggle to meet debt obligations, even if EBITDA looks strong.
• SBA loans and other lenders closely monitor CADS to ensure borrowers have sufficient cushion for debt payments.
• Helps buyers and investors evaluate financial risk in an acquisition, particularly in debt-heavy transactions.

3. EBITDA: A Useful but Incomplete Metric

Definition: EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a widely used measure of operational profitability. However, it does not reflect the actual cash available for debt repayment or reinvestment.

Why EBITDA Still Matters:

• Helps assess core business performance and profitability before financing and tax impacts.
• Useful for valuation multiples in M&A transactions.
• Often used in comparative financial analysis between companies in similar industries.

The Limitation: EBITDA does not account for CapEx, working capital needs, or debt service, making it insufficient for determining a company’s ability to sustain long-term growth.

Additional Financial Metrics to Consider

4. Operating Cash Flow (OCF)

Definition: Measures the cash generated by normal business operations before capital expenditures and financing activities.

Why OCF Matters:

• Provides insight into whether a business generates sufficient cash to sustain day-to-day operations.
• Highlights how efficiently a company converts revenue into cash flow.

5. Debt Service Coverage Ratio (DSCR)

Definition: Compares a company’s available cash flow to its debt obligations.

Why DSCR Matters:

• Essential for lenders assessing a company’s ability to repay its loans.
• A higher DSCR indicates a stronger ability to manage debt.

6. Working Capital

Definition: The difference between current assets and current liabilities, representing a company’s short-term financial health.

Why Working Capital Matters:

• Ensures a company has enough liquidity to manage daily operations.
• A negative working capital trend could indicate financial distress.

In Summary: How These Metrics Guide Smarter Deal-Making

• Free Cash Flow (FCF): Shows how much cash is truly available after essential expenses and investments. A strong FCF indicates financial flexibility and growth potential.
• Cash Available for Debt Service (CADS): Determines whether a business can meet its debt obligations. Crucial for any acquisition involving leveraged financing or SBA-backed loans.
• EBITDA: A useful measure of operational performance but does not provide a complete picture of cash availability for reinvestment or debt repayment.
• Operating Cash Flow (OCF): Evaluates how well a company generates cash from operations.
• Debt Service Coverage Ratio (DSCR): Indicates the ability to manage debt payments.
• Working Capital: Measures short-term financial health and liquidity.

While EBITDA helps understand profitability, FCF and CADS provide the real financial insights needed to make sound investment decisions.

For lower middle market deal-makers, these cash flow metrics are no longer just strategic advantages—they are absolute necessities. Lenders are more selective, LPs are deploying capital more cautiously, and deal scrutiny has never been higher. By focusing on FCF and CADS, buyers and investors can ensure they are acquiring businesses with strong financial fundamentals, setting themselves up for sustainable, high-value transactions in this evolving market. For fund managers, the pressure extends beyond acquiring strong assets—it includes ensuring that investments can withstand economic uncertainty. With financing becoming more expensive and harder to secure, CADS is now a critical metric for evaluating debt sustainability, while FCF ensures that portfolio companies have the cash flow to fuel growth post-acquisition.

Looking Ahead: The Future of M&A in 2025

As we approach 2025, economic conditions will continue to shift with potential fluctuations in interest rates, inflation, and credit availability. However, one constant remains—the need for deeper financial insights and a focus on cash flow metrics.

• Deal-makers who prioritize FCF and CADS will be better positioned to navigate uncertainty, make more informed investment decisions, and build long-term value.
• In today’s M&A environment, understanding and mastering these metrics isn’t just an advantage—it’s the key to success.

Are you incorporating these key cash flow metrics into your deal-making strategy?

Contact us today to learn how we can support your next deal.