THE CALL · THE LOAN · CAPACITY
A US$35m loan was sized on EBITDA of US$10m. Halfway through the year, management cuts its forecast to US$7m.
// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON
Free Cash Flow for Lenders: a Worked Example
What the business can pay the bank, once it has paid everyone else.
BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED · 6 MIN READ
// THE SHORT ANSWER
Free cash flow, as a lender uses the term, answers one question: once a business has met every claim that in practice comes before the bank, how much cash is left for interest and repayments? Tax actually paid comes out, then the cash that working capital absorbs, then the capital spending needed to keep the business running and, in accounts under IFRS 16, the lease payments that no longer pass through EBITDA. What remains is set against the bank's debt service. Because companies, valuers and facility agreements each draw the line in their own places, a lender builds this figure itself.
BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.
// WORK THE SUM
Every Groundwork file that is a number to work out — cash conversion, debt service cover, expected loss, risk-weighted assets, the margin on a bank's own book — with the working shown in the senior read. One minute each, no signup.
PART OF Credit Analysis for Beginners
// 01 — WHY A LENDER BUILDS ITS OWN
A lender is repaid from cash, not from profit, and not all cash is free to repay it. A business has to pay its tax, fund the stock and debtors that come with higher sales, and replace the vessels, vehicles or machines that wear out, or it stops being the business the bank lent to. The lender's free cash flow takes those out first and leaves the amount from which interest and principal can be paid without borrowing again or running the business down. It is a common numerator for debt service cover, and its deductions are the ones the lender expects to recur.
No accounting standard defines it, and a cash flow statement does not print it. Many mid-market borrowers do not produce a cash flow statement at all: a small UK company under FRS 102 need not prepare one, and special-purpose accounts in New Zealand and Australia often omit it. The lender then builds the figure from the profit and loss account and two balance sheets.
// 02 — HOW IT IS BUILT
EBITDA
− tax paid in the period (not the tax charge)
− increase in working capital (+ decrease)
− maintenance capital spending
− lease payments, where EBITDA is on the IFRS 16 basis
= free cash flow before debt service
Debt service cover = free cash flow ÷ (interest + scheduled principal)
Each line is a judgement. Cash taxes are what left the bank account, which can differ from the charge for years. Working capital is read against its normal level, because one period's movement can flatter or punish. Maintenance spending is the hardest line: the borrower's split between maintenance and growth is a starting point, which the lender tests against depreciation and the age of the assets (capex to depreciation). Growth capex is left out on the reasoning that the business could stop it and often funds it separately. And under IFRS 16 the cost of capitalised leases sits below EBITDA, with the principal in financing cash flows, so a lender building from EBITDA deducts the lease payments itself.
// 03 — THE EXAMPLE
A regional ferry operator, constructed for this page like every figure in it, runs four vessels from a leased terminal and reports under IFRS 16, so the terminal lease sits outside EBITDA. This year it also bought a fifth vessel for US$6.0m with a new term loan. Its bank interest is US$2.5m and scheduled principal US$3.0m. In US$m:
EBITDA 18.0
Tax paid − 2.4
Working capital build − 0.8
Maintenance capex: dry-docking, engines − 5.5
Terminal lease paid: 1.4 principal + 0.4 int. − 1.8
Free cash flow before debt service 7.5
Debt service cover: 7.5 ÷ (2.5 + 3.0) = 1.36×
Lease left out: 9.3 ÷ 5.5 = 1.69×
The operator's own free cash flow (operating cash flow − all capex):
(18.0 − 0.8 − 2.4 − 2.5 − 0.4) − (5.5 + 6.0) = 11.9 − 11.5 = 0.4
The operator can say it generated almost no free cash flow, and on its definition that is right: it paid its bank interest and bought a ship. The lender's 7.5 answers a different question, what the fleet produces for the bank if the business stops growing, and it is the figure that will have to carry the new loan's repayments as well as the old. The second cover line shows the IFRS 16 trap. A lender that starts from EBITDA and forgets the terminal lease overstates cover by a third of a turn. These levels are the example's and say nothing about the cover a lender looks for.
// 04 — HOW IT DIFFERS FROM A VALUER'S FREE CASH FLOW
Valuation works with free cash flow to the firm: operating profit taxed at the statutory rate as if the business had no debt, plus depreciation, less all capital spending and the investment in working capital. It is built to value the whole business over its life, so it charges notional tax and treats growth spending as part of the plan. The lender's figure uses the tax actually paid, because that is the cash that left, and sets growth spending aside, because the question is whether the existing business can service the debt. Free cash flow to equity, after debt service, is what the owners could take out; a lender reads it mainly as the room left for dividends. Project lenders ask the same question of a single asset through CFADS, with the deductions listed in the finance documents.
DEFINED IN ONE PARAGRAPH → · CASH FLOW ANALYSIS FOR BUSINESS LENDING → · MAINTENANCE CAPEX →
// 05 — WHERE IT DECIDES A FILE
In a new lending decision, free cash flow sets how much debt the business can carry on a given repayment profile, and the argument with the borrower is usually about maintenance spending. A borrower that books engine overhauls as growth raises its free cash flow on paper; the lender looks at what the fleet needs across a cycle of surveys and refits, not in the year in hand. The other argument is about leases and hire purchase: payments on equipment financed outside the bank are fixed claims that rank ahead of it in practice, whatever the accounts call them.
In the facility agreement, a cash flow cover covenant may use a contractual definition that departs from the lender's own, for instance by deducting all capital spending, or by leaving out tax on a one-off sale. The credit paper reconciles the two, so that the approver knows whether the covenant measures what the analysis does.
// SOURCES
The documents the statements on this page rest on. Each was opened and checked when cited.
- Australian Accounting Standards Board, AASB 16 Leases (compiled, applicable from 1 January 2024), the Australian text of IFRS 16 — paragraph 50 — Classifies the principal part of lease payments as financing cash flows, which is why a lender deducts lease payments itself — sections 02 and 03.
// QUESTIONS PEOPLE ASK
- Is free cash flow before or after interest?
- It depends on who is using the term. A lender strikes its free cash flow before interest and principal on its own debt, so that it can divide the result by debt service. Many companies publish a free cash flow after interest, and often after all capital spending, because they are showing what is left for shareholders. Equity analysts' levered free cash flow is after debt service too. Before comparing two free cash flow figures, check which payments each has already deducted.
- Why do lenders deduct maintenance capex but not growth capex?
- Because maintenance spending keeps the existing business able to earn what it earns, while growth spending expands it and can usually be delayed or funded separately. A lender testing whether today's business can service today's debt deducts the first and sets the second aside. The difficulty is the split: borrowers have an incentive to call spending growth, so lenders compare the maintenance figure with depreciation, the age of the assets and what the business has spent over several years.
- How does IFRS 16 change free cash flow?
- It moves lease costs out of EBITDA and the principal part of lease payments into financing cash flows. A free cash flow built from EBITDA or from operating cash flow therefore rises, though the business pays exactly the same rent. A lender who wants a figure comparable with earlier years, or with a borrower that owns its premises, deducts the lease payments, principal and interest, before setting the result against bank debt service.
- What is the difference between levered and unlevered free cash flow?
- Unlevered free cash flow is the cash a business generates before any payments to lenders, usually calculated with tax on operating profit as if it had no debt; it is used to value the whole business. Levered free cash flow is what remains after interest and debt repayments, the cash available to shareholders. A lender's free cash flow sits nearer the unlevered figure, but uses tax actually paid and deducts only the capital spending the business cannot avoid.
// NEXT TO IT
- READING THE NUMBERSCash taxes (tax paid)The profit and loss account accrues the tax. The bank account pays it.
- READING THE NUMBERSCapex-to-depreciation ratioThe accounts say the plant is wearing out. Is anyone replacing it?
- READING THE NUMBERSGrowth capex (expansion capex)The cash leaves this year. The earnings arrive in two.
- READING THE NUMBERSDebt capacityStart from the cash, and the loan is the answer, not the question.
// ON WHOSE DESK
The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.
- Credit analystReads a borrower and writes the recommendation a decision-maker will act on.
- Credit sanctionerHolds delegated authority and signs — or declines — the lending the front line brings.
- Portfolio managerOwns the credit on a book after the money is out — reviews, covenants, ratings and early warning.
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