Discretionary cash flow: A guide for business owners.
Cash flow is one of the clearest indicators of a small business’s financial health, but not all cash flow tells the same story. For small business owners who are planning to grow, invest or seek financing, understanding discretionary cash flow provides a more complete picture of both your day-to-day resilience and your long-term growth prospects.
Learn what discretionary cash flow is, how it’s calculated and how it can help position your business for sustainable growth.
What is discretionary cash flow?
“To understand discretionary cash flow, you first have to understand core cash flow, which is the cash that your business generates through daily operations, and that indicates sustainability,” according to Annastacia Bushman, senior underwriter in Commerce Bank’s Small Business Banking division. “But what about looking beyond sustainability? That’s where you’re going to find your discretionary cash flow.”
Discretionary cash flow is the amount of cash your business has left after covering all of your mandatory operating expenses, required debt payments and necessary capital expenditures. “Capital expenditures, or CapEx as we typically call it, refers to capital investment in your long-term assets,” Bushman said. “In other words, funds used by a company to acquire, upgrade and maintain physical assets like property, plant and equipment.” Capital expenditures are usually divided into maintenance CapEx, which are the funds that you use to maintain your existing assets, and growth CapEx, which are the funds you use to undertake new projects or investments.
Bushman said that while discretionary cash flow isn’t one of the core metrics that she and her colleagues consider during the underwriting process for small businesses, it does serve a useful purpose.
“Discretionary cash flow can help us better predict the growth or trajectory of the company, and it can also help our team have more productive conversations with customers,” Bushman said. “For example, if we notice that there’s a large surplus of cash remaining after operations and CapEx, then we can talk to the customer about future growth or projects that they might be planning, which helps us tailor lending services to them.”
How to calculate discretionary cash flow.
There’s no universal formula for calculating discretionary cash flow, and in small business lending, it’s not always calculated explicitly, Bushman said.
“Our cash flow model already removes non-recurring and non-cash items and adds back things like the owner’s salary, so we’re getting part of the way there,” she said.
While approaches to calculating discretionary cash flow vary, two common methods start with either net income or EBITDA (earnings before interest, taxes, depreciation and amortization):
Method 1
Net income + non-operating, non-recurring and non-cash expenses − non-operating and non-recurring income + owner’s salary and benefits
Method 2
EBITDA + non-recurring expenses − non-recurring income + owner’s salary and benefits − total debt service − maintenance CapEx
Discretionary cash flow vs. free cash flow.
“Discretionary cash flow is often compared to free cash flow, and some lenders will use those terms interchangeably,” Bushman said, “especially on the small business banking side.”
At a high level, both metrics show how much cash a business has left after covering key expenses. But they can differ in how that cash is defined and adjusted.
Free cash flow is typically a more standardized measure. It looks at the cash remaining after operating expenses and capital expenditures, offering a broad view of financial performance.
Discretionary cash flow, on the other hand, can take a more flexible approach. In more detailed financial models — particularly on the commercial side — lenders may adjust for additional factors such as owner distributions, growth investments and changes in working capital.
What your discretionary cash flow tells lenders.
According to Bushman, strong discretionary cash flow can give owners choices — and lenders and potential investors confidence.
“Since discretionary cash flow can be used for things like dividend payouts, paying down debt outside of debt obligations, and further investment back into the company, a strong discretionary cash flow indicates a company’s ability to safely make additional investments or take on additional debt without disrupting the ability to repay their current debt obligations,” Bushman said.
In other words, strong discretionary cash flow signals to lenders that you can comfortably service your existing debt, absorb unexpected expenses and even take on new borrowing if necessary. All of that can make your business more creditworthy than a company that’s only able to meet its current obligations.
Strong discretionary cash flow also makes it easier for your company to grow, Bushman said, “because third-party investors see your company as a safer investment and more likely to generate long-term returns.”
It’s not just about the number, however. The decisions a business makes with discretionary funds are just as important.
“As with other financial metrics, there’s a qualitative human side as well,” she said. “If there are two companies with the same strong discretionary cash flow, but one owner decides to pay themselves all of the discretionary funds to go buy a large boat, for example, and the other owner decides to reinvest in equipment that helps them produce additional revenues in the following year, one of those owners is a safer bet than the other.”
For companies that are seeing a downward trend in their discretionary cash flow, Bushman recommends providing details about why it dropped, especially when it reflects a deliberate long-term investment decision rather than simple financial strain.
“For example, maybe you reinvested your prior year’s discretionary cash flow into owner-occupied real estate. Now, your debt payments are higher than what your rent previously was, but you also now have a stronger balance sheet with real estate that’s going to hold its value over time,” Bushman said.
How to put discretionary cash flow to work for your business.
Since no two small businesses are exactly the same, there isn’t one single formula for how to use discretionary cash flow, according to Bushman. “It’s really up to owners to decide the best use for their discretionary funds.”
These are some of the ways that business owners may decide to use discretionary funds:
- Reinvest in equipment, technology or talent
- Build financial reserves to manage uncertainty
- Pursue strategic growth opportunities
- Pay off debt sooner and improve financial flexibility
The key is choosing options that support your short-term stability and your long-term growth. “Don’t use all your discretionary funds to pay off all your debt if that means you’re going to drain all of your liquidity to do it,” Bushman said. “You’ve got to find that balance for you and your business.”
That kind of judgment call is easier to make when you have a clear view of your finances. Understanding your discretionary cash flow gives you a clearer picture of where your business stands and what’s possible. When you know what’s left after obligations are met, you’re better equipped to make smart decisions about growth, staffing, equipment or simply building a cushion for what’s ahead.
