From Free Cash Flow to the Firm to Cash Flow Available for Debt Service

A lender looking at a business works from figures it computes itself. A credit analyst takes the statements, applies the definitions in the bank's standard credit agreement, and works out the cash the business has available to pay interest and principal. If the business has never computed that figure, the analyst's version is the only one in existence. If the business has computed it three times for three different requests and got three slightly different answers, the analyst uses the lowest.

The first span of the fourth bridge teaches the business to state its cash in the lender's terms. By the end of the third bridge it can state its free cash flow to the firm and defend it to a buyer who models. On this span it learns to produce the lender's figure as well, every month, on the lender's definition and reconciled to the statements, and to know every claim on that cash that ranks ahead of the owners.

What the measure is

Cash flow available for debt service is the lender's own definition of the business's cash. It is the numerator of the ratio every senior lender lives by, debt service coverage, which divides that cash by the interest and principal due in the period. A coverage ratio of 1.25, for example, means the business produces a quarter more cash than its debt payments require. The definition sits in the loan agreement and differs in detail from lender to lender, but the logic holds everywhere: start from the business's cash, adjust it to the lender's view of what is truly available, and compare the result with what is owed.

It comes first on the bridge because a lender computes it first. Debt capacity, the next span's measure, is a multiple of it, and every later measure on the bridge, from the size of the facility to the covenant tests to the equity left over, is built on it. Whatever else a business has proved, if the lender's number is uncertain it will be lent against cautiously.

The two drivers

Lender Reporting produces the lender's number every month. The finance seat sends a lender pack on a fixed day soon after each month-end, holding the statements, cash flow available for debt service on the loan agreement's definition, a line-by-line bridge to it from free cash flow to the firm, and every covenant test. The definitions are adopted before the first pack, from a typical senior credit agreement or from the term sheet once there is one, and every line of the bridge ties to the statements.

Capital Structure File puts every claim that ranks ahead of the owners on one schedule. Every loan, lease, deferred payment, earn-out, deferred bonus, customer deposit and shareholder loan is listed with its amount, terms and source document. Every shareholder loan is papered and subordinated to the senior lender. And the capitalization table agrees with the share register and the shareholder agreement, so that no claim, an informal promise of equity to a long-serving employee included, can surface ahead of the lender or the buyer.

From the business's number to the lender's

The two figures are close but not the same, and analysts and owners usually disagree in the differences.

Free cash flow to the firm deducts tax as though the business had no debt, because it values the whole enterprise before any financing. A lender cares about the tax the business actually pays, which is lower once interest is deductible. Free cash flow to the firm also deducts all capital spending, where a typical credit agreement deducts only the spending the business funds from its own cash and leaves out growth spending paid for by a committed facility. And the agreement permits some add-backs and refuses others. In the illustration, a business with $765,000 of free cash flow to the firm presents $950,000 of cash available for debt service once those three adjustments are made, and with $624,000 of interest and principal due, its coverage is 1.52.

The adjustments themselves are easy. The business has to make them itself, line by line, each with its source account, and the same way every month. A lender who has received the same figure, built the same way, for two years running stops recomputing it. One who has to assemble the figure from scattered requests sizes the debt on the lowest answer it got.

What it does to value

Neither driver changes the business's cash, so the value the framework credits them with is narrow, and it runs through the probability of a breach.

Lender Reporting ranks seventh on the bridge. Monthly covenant tests on the agreement's own definitions show a tightening covenant months before the lender's quarterly test, while there is still time to act, and the fall in breach probability that buys is the value counted. The better margin, the willingness to lend and the wider pool of lenders a clean pack attracts are real, and they are price. Capital Structure File ranks eighth on the same reasoning: an obligation already on the schedule cannot surprise a covenant test. The debt-like items it lists would otherwise turn up in diligence, and their dollar amount is an error corrected once in the equity value at the closing table. The obligation was always owed, so listing it early creates nothing.

How the drivers depend on each other

The two drivers meet in the covenant tests. Most senior facilities test leverage as well as coverage, total debt divided by EBITDA, and the debt in that test is whatever the agreement counts as debt. A pack that reports leverage without the schedule reports a number diligence will later raise, and a schedule that never appears in the pack is a file nobody reads. Together they give the lender one reconciled figure for the cash and one for the claims on it.

Both rest on work the business has already done. A pack due so soon after month-end is possible only on top of the fast close built on the second bridge. The bridge from free cash flow to the firm starts from the capital spending classification and the working-capital peg inspected at the start of this bridge, so if those move, the pack moves with them. The schedule starts from the related-party schedule built under Separation, where the shareholder loans and owner arrangements were first listed, and from the material contracts transferred into the company's name, where the deposits and deferred obligations are found. And the schedule's classification of each item as debt, debt-like or working capital has to agree with the peg, or the same balance will be counted twice, once in working capital and once as debt.

How a credit analyst reads the work

A credit analyst given two years of packs reads them for consistency before reading them for level. Does the bridge from free cash flow to the firm contain the same lines every month, from the same accounts? Do the covenant tests use the definitions in the term sheet, or something close to them? Is there a month where an add-back appears once and never again? The analyst will rebuild one month from the statements, and if the result matches the pack, the rest are believed. The schedule is read against the contracts. A deposit clause in a customer agreement with no line on the schedule tells the analyst the schedule was built from balances, not documents, and every other line then gets checked by hand.

The owner can run the same tests first: recompute one month of the lender's figure from the statements and the definition without the finance lead's help, and sign the schedule as complete. That signature is the representation a credit agreement and a purchase agreement will later ask the owner to make.

How the span comes undone

Month-ends run late and the pack slips past its day, breaking an unbroken record of on-time packs. The finance function hollows out until the owner is assembling numbers for the bank again. And debt-like obligations pile up off the schedule, one equipment lease or deferred bonus at a time.

What holds the span is making each lapse visible as it starts. Once debt is in place, the pack's deadline is written into the loan agreement's reporting covenant, so a late pack becomes a breach. A named deputy prepares a pack every quarter, so it survives the finance lead's absence without the owner stepping back in. Every contract with a deferred payment passes the finance lead before it is signed, and a quarterly sweep of new contracts against the schedule catches whatever slipped past.

Crossing the span

The span is crossed when lender-grade reporting exists and the lender's number reconciles to the statements, and when every debt and debt-like obligation sits on one schedule. The next span asks how much debt that number can carry when things go wrong.