Why is free cash flow more important than EBITDA in an LBO?

Because debt is repaid with cash, not with EBITDA. A business can grow EBITDA while generating little free cash flow if capex and working capital absorb the earnings, which limits how fast the sponsor can delever.

How does working capital affect free cash flow?

Growth in net working capital consumes cash as receivables and inventory build, so a fast-growing, working-capital-heavy business can show rising EBITDA and weak free cash flow at the same time.

Free Cash Flow (FCF) - The Cash That Pays Down LBO Debt

Q: How is free cash flow calculated in an LBO?

A working definition is EBITDA less cash interest, less cash taxes, less capital expenditures, less the increase in net working capital. What remains is the cash available to service and repay acquisition debt.

Free Cash Flow (FCF) is the cash a business generates after funding its own operations and reinvestment, and the cash available to service and repay debt. A working LBO definition is EBITDA less cash interest, less cash taxes, less capital expenditures, less the increase in net working capital. It is the number that turns earnings on paper into cash in the account.

Why it matters

Free cash flow, not EBITDA, is what pays down acquisition debt. The strength and predictability of FCF is what makes a business a good LBO candidate and sets how fast the sponsor can delever. A lender sizes the debt to the cash that can service it, and a sponsor underwrites the deal to the cash that can repay it, so the quality of FCF is often the difference between a financeable deal and one that is not.

Worked example

Walking EBITDA to free cash flow

A business with $25M of EBITDA, $6M of cash interest, $3M of cash taxes, $4M of capex, and $2M of working-capital build generates $10M of free cash flow available for debt paydown that year. The $15M gap between EBITDA and FCF is exactly the cash that EBITDA alone would have told you was there and is not.

The common mistake

Ignoring working capital. A growing distributor ties up cash in receivables and inventory as it scales, so rising EBITDA can coincide with weak FCF. This is exactly why working-capital-heavy deals are modeled carefully, and why the net working capital build is one of the first things a buyer stress-tests. The traps that quietly inflate FCF are covered in 5 Common LBO Modeling Traps.