Levered vs. unlevered free cash flow explained (formulas, examples, definitions)

Are investors, auditors, or banks evaluating your company? Or are you aiming to optimize your operations to boost cash flow?

Either way, understanding levered and unlevered free cash flow is crucial for assessing profitability and the impact of debt on your business.

In this article, we’ll explain the nuances between levered and unlevered free cash flow with detailed formulas, examples, and key definitions to help you manage your cash flow effectively.

What is free cash flow?

Free cash flow (FCF) refers to the cash that remains after a company has covered its operating expenses and capital expenditures. This cash can be used to pay dividends, reduce debt, or invest in growth opportunities.

Companies use free cash flow to evaluate their profitability and financial health. Free cash flow provides insights into your company’s ability to generate additional revenues, manage capital expenditures, and handle changes in working capital, as seen on the balance sheet. FCF excludes non-cash expenses, such as depreciation and amortization, which are reported on the income statement.

Levered free cash flow

Similarly, levered free cash flow (LFCF), also referred to as “free cash flow to equity,” is the cash that is available to stakeholders and equity holders after a company has covered its operating costs, reinvestments, and debt obligations.

However, this cash is not necessarily always distributed directly to stakeholders. It is up to management to decide whether to reinvest these funds into operations, buy back stocks, or issue dividends to equity shareholders.

Unlevered free cash flow

Unlevered free cash flow (UFCF), also referred to as “free cash flow to firm,” is the cash a company generates from its operations before accounting for any debts or interest payments. It shows how much cash the business produces purely from its core activities, independent of its capital structure. This amount can be used to pay both debtholders and shareholders.

Essentially, UFCF is a measure of the company's overall financial health, demonstrating its ability to generate cash to cover all its financial obligations.

Free cash flow (FCF) vs. free cash flow yield (FCFY)

As we mentioned above, free cash flow is a measure of how much cash remains after a company has covered its operating expenses and capital expenditures. Free cash flow yield, on the other hand, calculates how much of this free cash an investor is entitled to relative to the company’s market value.

It’s preferable to have a high free cash flow yield, as it indicates a company has cash to pay down debts, distribute dividends, and reinvest into its operations, compared to a low free cash flow yield.

Levered vs. unlevered free cash flow: key differences

Now that you’re familiar with the definitions of free cash flow, free cash flow yield, levered free cash flow, and unlevered free cash flow, let’s cover the nuances between levered vs. unlevered free cash flow.

Fórmulas

Levered and unlevered free cash flow are similar, but unlevered free cash flow represents the total cash a company has available before accounting for any debt payments. In contrast, levered cash flow deducts payments and debts from the total amount. For this reason, the formulas to calculate levered vs. unlevered free cash flow differ:

Levered free cash flow formula = EBITDA – change in net working capital – capital expenditures (CAPEX) – debt repayments (D)

Onde:

• EBITDA = Earnings before interest, taxes, depreciation, and amortization
• Change in net working capital = Change in the difference between current assets and current liabilities
• CAPEX = Capital expenditures (e.g. investments in buildings or equipment)
• Debt repayments = Payments made towards reducing debt

Unlevered free cash flow formula = EBIT + depreciation & amortization – CAPEX – change in working capital – taxes

Onde:

• EBIT = Earnings before interest and taxes
• Depreciation & amortization = Non-cash expenses that reduce the value of assets over time
• CAPEX = Capital expenditures (e.g. investments in buildings or equipment)
• Change in working capital = Difference between current assets and current liabilities
• Taxes = Local, state, or federal taxes

Inclusion of expenses

As mentioned above, levered free cash flow includes expenses related to debt repayments and interest, whereas unlevered free cash flow does not include these debt obligations. However, both levered and unlevered free cash flow include capital expenditures. Essentially, unlevered free cash flow measures the cash available to equity and debt holders before paying debt obligations, while levered free cash flow measures the cash available after debt obligations have been paid.

Reasons for tracking

Companies track levered free cash flow for budgeting, as it gives them a clearer picture of how much cash is available for investments after debt obligations are paid. Unlevered free cash flow is often used to assess operating cash flow, as it provides a holistic view of how much cash is being generated from operations before accounting for debt obligations.

Financial obligations

Before stating your final levered free cash flow, you must settle your debt obligations. In contrast, you can finalize your unlevered free cash flow without settling your debt obligations. This does not imply that a company isn’t responsible for their debt repayments and expenses, but it’s not necessary to include these in the calculation of unlevered free cash flow.

Importance to financial health

Levered free cash flow is a better measure of an organization’s profitability because it accounts for debt obligations and expenses. However, unlevered free cash flow is important to an organization’s financial health because it highlights the gross cash amount available, which can be used to assess the company's ability to generate cash independent of its capital structure.

Intention and transparency

Selecting levered free cash flow or unlevered free cash flow depends on your intentions, and the level of transparency you’d like to provide. Unlevered free cash flow is often used by banks and investors to understand how profitable a company’s operations are.

In contrast, levered free cash flow is used by business owners to make decisions about future capital investments, as it shows the cash available after meeting debt obligations. Generally, unlevered free cash flow provides a clearer picture of operational performance, while levered free cash flow offers a more comprehensive view of financial health by including debt obligations and interest expenses.

Desvantagens

There are unique disadvantages to both levered and unlevered free cash flow. Unlevered free cash flow can be easily inflated, making a company’s operating income seem higher than it is. Basing decisions on unlevered free cash flow can lead to overestimating available cash, because it’s not an accurate picture of free cash flow with debt obligations and expenses excluded.

Levered free cash flow can be difficult to calculate as working capital is always changing. Levered free cash flow can also paint an unnecessary negative picture of a company’s financial health by focusing on debt obligations, but often, debt can be a tool to support growth.

Each metric tells a different story about the business's finances

In short, each metric, whether levered or unlevered, tells a different story about a business’s finances and is used in different circumstances. However, both levered and unlevered free cash flow can give finance leaders insight into their profitability and organizational health, supporting long-term strategic decision-making.

Levered free cash flow calculation example

Now, let’s take a look at the levered free cash flow formula and an example of how to calculate it.

As a quick refresher, the levered free cash flow formula is:
Levered free cash flow = EBITDA – change in net working capital – capital expenditures (CAPEX) – debt repayments (D)

Exemplo

To make this concept clearer, let's go through an example. Suppose Company C has the following financial data for the year:

• EBITDA: $1,000,000
• Change in net working capital: $50,000 (increase)
• CAPEX: $200,000
• Debt payments: $100,000

Using the formula, we can calculate the levered free cash flow as follows:

Levered free cash flow formula = EBITDA – change in net working capital – capital expenditures (CAPEX) – debt (D)

Levered free cash flow = $1,000,000-$50,000-$200,000-$100,000

Levered free cash flow = $650,000

So, Company C’s levered free cash flow for the year is $650,000. This figure gives a comprehensive view of the actual cash available after accounting for both capital expenditures and debt obligations.

Unlevered free cash flow formula & calculation example

Next, let’s look at the unlevered free cash flow formula and an example to illustrate its use.

As a quick refresher, the unlevered free cash flow formula is:
Unlevered free cash flow formula = EBIT + depreciation & amortization – CAPEX – change in working capital – taxes

Exemplo

Suppose Company D has the following financial data for the year:

• EBIT: $1,000,000
• Depreciation & amortization: $200,000
• CAPEX: $300,000
• Change in working capital: $50,000 (increase)
• Taxes: $100,000

Using the formula, we can calculate unlevered free cash flow as follows:

Unlevered free cash flow formula = EBIT + depreciation & amortization – CAPEX – change in working capital – taxes

Unlevered free cash flow = $1,000,000+$200,000-$300,000-$50,000-$100,000

Unlevered free cash flow = $750,000

So, Company D’s unlevered free cash flow for the year is $750,000. This figure provides an insight into the cash generated by the company before accounting for debt obligations, reflecting operational efficiency.

Forecasting unlevered free cash flow in a DCF model

Unlevered free cash flow is often forecasted in the creation of a discounted cash flow (DCF) model. A DCF model states that the value of a company depends on the sum of its future cash flows discounted to the present rate. The formula is:

Company value = cash flow / (discounted rate – cash flow growth rate)

Generally, DCF models hold more value for early-stage companies, whose cash flow growth rate changes over time. Unlevered free cash flow is used in this calculation because it isn't affected by a company’s capital structure.

Valuation multiples and discount rates with levered and unlevered FCF

In calculating your discounted cash flow, you can use valuation multiples and discount rates with levered and unlevered free cash flow to better understand a company’s value.

Valuation multiples

Valuation multiples are used to evaluate multiple financial factors of a company. For example, you can choose:

• Enterprise value (EV) multiples – e.g. EBITDA, EBIT, or revenue
• Equity multiples – e.g., earnings per share, book value per share, or dividends per share.
• Industry-specific multiples – e.g., price-to-earnings (P/E) or price-to-book (P/B) ratio

By selecting the metric that’s most relevant to your circumstances, you should calculate the valuation multiple for several comparable companies. Then, you can apply these findings to estimate the value of the company you’re considering. Finally, you can compare the valuation multiple against your DCF model and analyze the differences. If your valuation multiple is significantly higher or lower than your DCF model, you should reconsider your assumptions and inputs to see if they are realistic.

Discount rates

In the calculation of your DCF model, the discount rate is the interest rate used to determine the present value of future cash flows. This rate reflects the time value of money, accounting for the risk and opportunity cost associated with investing in a particular company. By discounting future cash flows, the DCF model translates them into today's dollars, allowing for a more accurate comparison of different investment opportunities.

When applying the discount rate, it’s important to consider factors such as the company's cost of capital, market risk premium, and the risk-free rate. A higher discount rate typically indicates greater risk and will result in a lower present value of future cash flows, whereas a lower discount rate suggests less risk and a higher present value.

If you find that your DCF model’s estimated value is significantly higher or lower than your valuation multiple, it may be necessary to adjust the discount rate. Reassess the assumptions underlying your discount rate to ensure they align with current market conditions and the specific risks associated with the company. Making these adjustments can help reconcile discrepancies and provide a more accurate assessment of the company's value.

Discussion: Why compare levered and unlevered free cash flow?

Comparing your levered and unlevered free cash flow can help you understand how your operating income is affected by debt obligations and expenses. For example:

• Debt influence on cash flow – By comparing your LFCF and your UFCF, you can better understand how debt affects your company’s cash flow. A significant difference between your UFCF and your LFCF indicates high debt servicing costs, which could impact your company’s financial health.
• Investment assessment – Banks and investors use both LFCF and UFCF to appraise a company’s value and the sustainability of its operations. Investors use LFCF to understand a company’s actual cash flow after their financial commitments and UFCF to see a company’s potential cash generation without the burden of debt.
• Leverage evaluation – By comparing LFCF with UFCF, a company can evaluate if their debt level is manageable and how it influences its overall risk profile.

Levered vs. unlevered free cash flow FAQs

Read on for answers to frequently asked questions about levered versus unlevered free cash flow.

What is free cash flow (FCF)?

Free cash flow (FCF) is the cash generated by a company after accounting for capital expenditures. It represents the discretionary funds available to pay dividends, reduce debt, or invest in growth opportunities. Unlike net income, free cash flow provides a clearer picture of a company's financial health by showing the actual cash available after all essential financial obligations have been met, including operating expenses and capital expenditures.

Is too much free cash flow bad?

No, too much free cash flow is not necessarily bad. Too much free cash flow may indicate that your company is in a strong financial position and can meet its financial obligations easily. This surplus may provide opportunities to invest in growth, pay dividends, or reduce debt. However, consistently high levels of free cash flow might also suggest that the company is not effectively reinvesting in its business, which could potentially hinder long-term growth. Therefore, while having substantial free cash flow is generally positive, it should be strategically managed to balance immediate financial health with future expansion.

Which is better, levered or unlevered FCF?

Levered and unlevered cash flow measure different aspects of a company’s financial health, so neither metric is inherently better.

Conclusion: Simplify free cash flow with Prophix One™

Understanding the differences between levered and unlevered free cash flow is important for accurate financial analysis and strategic decision-making. By mastering these concepts, you can better assess your company's financial health and the impact of debt on profitability.

Prophix One, a Financial Performance Platform, simplifies the calculation of both levered and unlevered free cash flow, allowing you to focus on driving growth and optimizing operations.

Learn more about our all-in-one Financial Performance Platform.