A challenge many business owners face is understanding the difference between debt service cash flow and free cash flow. This can lead to flawed capital strategies and miscommunication with lenders.
Some time ago we made a presentation to local banks about our free cash flow model. Since then we have received several requests for a summary of the presentation. We have found that our model is useful in understanding cash flow and formulating a strategy that satisfies both the owner and lender. Often business owners have executed a strategy that misappropriates the cash required to meet debt service covenants. This puts the company in default and lenders on edge. Business owners don’t realize they have eroded the debt service cash flow because the company remains profitable. A bottom line profit does not mean you will meet your debt service requirements. Remember, the key is cash flow.
Total Cash Flow – The black and yellow bar is a company’s cash flow, divided into two portions, debt service cash flow and free cash flow.
Debt Service Cash Flow is the portion of your cash flow that is required for you to remain in compliance with your loan documents.
Free Cash Flow (or discretionary cash flow) is the cash flow that you can direct to the following three categories:
1. Revitalization – (the maintenance phase) includes replacing equipment, upgrading processes, etc.
2. Growth/Change – (the innovation phase) includes new product development, new equipment, inventory growth, receivable growth.
3. Distributions/ROI – (the financial reward phase) includes bonuses and dividend distributions.
Cash strategy is about balancing free cash flow among these three areas while maintaining and preserving the debt service cash flow.