What is unlevered free cash flow and how to calculate itReading Time: 4 minutes
Before understanding unlevered free cash flow, we’ll break down the terms unlevered, cash flow, and free cash flow.
Businesses treat cash flow and free cash flow differently because they represent different metrics.
This article will highlight the following.
- Levered vs unlevered?
- What is cash flow
- What is free cash flow
- What is unlevered free cash flow
- How to calculate unlevered free cash flow
- What is levered and unlevered free cash flow?
- Difference between levered and unlevered free cash flow
Let’s get to understand,
Levered vs unlevered?
When starting up a business, it’s common for most entrepreneurs to seek loans from financial institutions or lenders.
These lenders provide financial assistance, meaning the business owners have a debt obligation. Hence, the word levered.
When entrepreneurs start a business without taking any loan from financial creditors, lenders, or financial institutions, this is unlevered.
This means the business owners didn’t seek external funding for the company’s capital or assets and have no debt obligation to external investors.
What is cash flow?
Cash flow shows the income and expenses you generate through daily business operations.
Cash received are inflows (Accounts receivable), while the monies you spend are outflows (Accounts payable).
You use the cash flow to prepare the cash flow statement (CFS), which summarizes the movement of cash and cash equivalents that go in and out of the company.
The CFS is complementary to the balance sheet and the income statement.
For a company to meet its obligation to stakeholders, it is essential to generate positive cash flows or maximize long-term free cash flow (FCF).
What is free cash flow (FCF)?
Free cash flow is your company’s cash after paying its operating expenses and investing in capital expenditures.
Free cash flow measures your company’s profitability, excluding the non-cash expenses of the income statement on the balance sheet.
Some investors prefer to use FCF or FCF per share over earnings or earnings per share as a measure of profitability because these metrics remove non-cash items from the income statement.
Free cash flow formula
FCF = Operating cash flow – Capital expenditures
FCF = Net income + non-cash expenses - increase in working capital - capital expenditures
What is unlevered free cash flow (UFCF)?
This is the cash your business has from cash flow activities, including debts.
However, the money excludes all operating expenses, capital expenditures, and investments in working capital.
Also known as Free Cash Flow to the Firm (FCFF), you use UFCF in financial modeling to determine your company’s enterprise value.
Technically, it is the cash flow that shareholders would have access to from your business operations.
Essentially, the UFCF number is an exaggerated number of your business’s worth if there are no debts.
How to calculate unlevered free cash flow
When calculating UFCF, you consider EBITDA.
Unlevered free cash flow formula
UFCF = EBITDA - Capital expenditures (CAPEX) - working capital - Taxes
EBITDA = Earnings before Interest, Tax, Depreciation, and Amortization: Companies used EBITDA to determine overall financial performance
Capital Expenditures = CAPEX are cash investments in property, buildings, machines, equipment, and inventory. It also includes accounts payable and accounts receivable.
Working capital: This is the total current assets – total current liabilities.
Taxes: The amount your company owes to regulatory bodies
Assuming your company recorded an EBITDA of $250,000 in the first year and $275,000 in the second year.
You purchased every item your business needs to operate at maximum capacity in the first year, resulting in a $200,000 spend.
In the first year, your working capital was $30,000. It grew to $50,000 in the second year. Taxes were $25,000 and $33,000 for the first and second years, respectively.
Here’s a table with the figures:
UFCF = EBITDA – Capital expenditures (CAPEX) – Working capital – Taxes
In the first year:
UFCF = 250,000 – 200,000 – 30,000 – 25,000 = -$5,000
And the second year:
UFCF = 275,000 – 0 – 50,000 – 33,000 = $192,000
Despite spending more on working capital and taxes, your company records a significant UFCF in the second year because CAPEX is reported in the first year.
Difference between levered and unlevered free cash flow
|Levered free cash flow||Unlevered free cash flow|
|It is your company’s money after paying off short- and long-term debts.||It is your company’s money, assuming nothing is paid to equity holders.|
|LFCF analysis considers the capital structure in calculating the company’s Cash flows. If a different capital structure is assumed, the LFCF analysis must be re-run.||UFCF analysis allows the test of different capital structures to determine how they impact a company’s value.|
|It assumes a business’s capital is borrowed and has debt obligations.||It assumes that all capital and assets belong to the owners|
|LFCF formula: EBITDA – change in net working capital – CAPEX – mandatory debt payments||UFCF formula:EBITDA – Capital expenditures (CAPEX) – Working capital – Taxes|
While UFCF presents exaggerated numbers for a business, it can serve as a comparative benchmark for your company.
Cash flow is estimated irrespective of the capital structure, allowing for direct comparison between your company and others.
Having negative numbers doesn’t always mean bad – it’s more important to understand the data and note trends over time.
Unlevered Free Cash Flow Frequently Asked Questions (FAQs)
- Why use unlevered free cash flow?
To determine the enterprise value of two companies.
- Is levered free cash flow the same as FCF?
No. It isn’t the same. Levered Free Cash Flow (LFCF) includes interest expenses and principal debt payments. Free Cash Flow (FCF) excludes principal debt payments and includes interest expenses.
- What is the difference between free cash flow and cash flow?
Free cash flow is a company’s cash after paying its operating expenses and investing in capital expenditures. Cash flow is the total amount of money transferred in and out of business.
- How do you calculate UFCF from EBIT?
EBIT is essentially Net income. To calculate UFCF from EBIT,
Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure.
To arrive at unlevered cash flow, add back interest payments or cash flows from financing.