Key Insight
SDE and EBITDA ignore capital spending. Free cash flow doesn't. A business that spends $80K/year replacing equipment isn't generating $80K more than one that doesn't — but SDE will say it is.
The FCF Formula
FCF = EBITDA − Taxes − Changes in Working Capital − Capital Expenditures (CapEx)
For practical SMB due diligence, the simplified version is: FCF ≈ SDE − Maintenance CapEx
Why Capital Expenditure Matters
EBITDA adds back depreciation as a non-cash charge — but depreciation exists because assets wear out and need replacing. A business with $200K EBITDA and $60K/year in required equipment replacement has $140K in true free cash flow, not $200K.
The relevant capital expenditure is maintenance CapEx — spending required to keep the business running at current capacity. Growth CapEx (spending to expand) is a discretionary investment decision.
In capital-light businesses (service, professional, software), maintenance CapEx is minimal and SDE approximates free cash flow well. In capital-intensive businesses (manufacturing, trucking, food service, HVAC), the gap between SDE and FCF is significant and matters for valuation.
HVAC company shows $320K SDE. Owner runs a fleet of 6 service vehicles. Average vehicle age: 7 years. Average replacement cost: $45K each. Annual maintenance CapEx implied: ~$40K. Actual FCF: ~$280K. A buyer who prices the deal on $320K SDE and then immediately faces two vehicle replacements in year one overpaid relative to true cash generation.
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