Why use unlevered free cash flow

Unlevered free cash flow can be reported in a company's financial statements or calculated using financial statements by analysts. Unlevered free cash flow shows how much cash is available to the firm before taking financial obligations into account.

The formula for unlevered free cash flow uses earnings before interest, taxes, depreciation and amortization EBITDA , and capital expenditures CAPEX , which represents the investments in buildings, machines, and equipment. It also uses working capital, which includes inventory, accounts receivable, and accounts payable. Unlevered free cash flow is the gross free cash flow generated by a company. Leverage is another name for debt, and if cash flows are levered, that means they are net of interest payments.

Unlevered free cash flow is the free cash flow available to pay all stakeholders in a firm, including debt holders as well as equity holders. Like levered free cash flow , unlevered free cash flow is net of capital expenditures and working capital needs—the cash needed to maintain and grow the company's asset base in order to generate revenue and earnings. Non-cash expenses such as depreciation and amortization are added back to earnings to arrive at the firm's unlevered free cash flow.

A company that has a large amount of outstanding debt, being highly leveraged, is more likely to report unlevered free cash flow because it provides a rosier picture of the company's financial health.

The figure shows how assets are performing in a vacuum because it ignores the payments made for debt incurred to obtain those assets. Investors have to make sure to consider debt obligations since highly leveraged companies are at greater risk for bankruptcy.

Interest expense often appears with differences in timing between interest accrued and interest paid. The difference between levered and unlevered free cash flow is the inclusion of financing expenses. Levered cash flow LFCF is the amount of cash a business has after it has met all of its financial obligations, such as interest, loan payments, and other financing expenses. Unlevered free cash flow is the money the business has before paying those financial obligations.

Financial obligations will be paid from levered free cash flow. The difference between the levered and unlevered cash flow is also an important indicator. The difference shows how many financial obligations the business has and if the business is overextended or operating with a healthy amount of debt. It is possible for a business to have a negative levered cash flow if its expenses are more than what the company earned.

Based on the content of this tutorial, our recommended Premium Course Upgrade is Learn More. Polygon 1 Created with Sketch. BIWS Platinum: The most comprehensive package on the market today for investment banking, private equity, hedge funds, and other finance roles. Now, we can plug all these into the formula, but first, we need to calculate the tax rate.

We divide the taxes by the operating income, which equals:. That is fairly straightforward once we know where to get the inputs. The inputs are standard line items, but one of them that is a little more off the usual radar is the change in non-cash working capital. The usual standard fare is to use either the difference between current assets and current liabilities to determine the change in working capital.

Or, to use the change in working capital, you can calculate from the cash flow statement. However, per both Aswath Damodaran and Michael Mauboussin, a more accurate method is to use the non-cash working capital.

The reason for this is it gives us a better insight into the working capital the company is using to drive growth. If this is confusing, please refer to the following link to better explain:. We need to discuss the growth rate for revenues, which moves down the line to the unlevered cash flows. There are three ways to go about determining the growth of revenues.

The first is to use historical growth rates for the company and project those forward. The second method is to use analyst estimates, which you can gather from any of your favorite financial websites such as Yahoo, Gurufocus, Seeking Alpha, or any that you use. The analysts that follow the company issue growth estimates every quarter, based on their estimates or projections from the company itself. Each quarter, before Covid, every company would issue guidance on revenue growth.

These are perfectly fine but no better than estimates you might assume on your own. Studies have shown that humans, in general, are terrible at forecasting the future, and analysts are no better. Not trying to run them down; I only want to highlight options.

To do this, we will use the above numbers from our unlevered cash flow calculations:. Next, we calculate the return on capital ROC , which we use the above NOPAT and divide that by the debt, equity and subtracting the cash and equivalents from the balance sheet. That growth rate we calculated for Intel will be the rate we project the revenues for the company into the future.

The next item we need to discuss is the operating income or earnings. These are the earnings that we project as unlevered cash flows and help us determine a fair value for the company. Operating margins tend to be more stable than net income or net earnings, and for a company to improve its operating margins, they need to move the needle on efficiencies.

Another critical aspect is to consider where the company is in its life cycle. The inclusion of this expense lowers taxable income. When we add interest expense back, we need to remove this benefit from the bottom line. If not, we would have artificially-low taxes paid. Levered free cash flow is also known as free cash flow to equity FCFE. The idea is that FCFE includes the impact of debt on cash flow, including interest expense.

Because debt holders have higher-ranking rights, equity holders only get paid after debtors. The company has a real, non-theoretical cash flow after interest expenses and principle repayments. We can therefore calculate levered free cash flow by starting with unlevered free cash flow and subtracting interest expense and reversing any tax we had incurred from interest expense, aka the tax shield , which is only relevant if we used CFO for unlevered FCF , then subtracting debt payments.

Levered free cash flow and simple free cash flow account for interest expense, but unlevered free cash flow does not reduce cash by interest expense. None of the 3 types of free cash flow include dividends. Moreover, they are used as metrics to determine how much dividends could be paid out of a company. None of the 3 types of free cash flow consider depreciation as a cash-reducing item because depreciation is non-cash.

Levered free cash flow reduces cash flow by debt principle payable from the financing activities section of the cash flow statement, but simple free cash flow and unlevered free cash flow do not consider debt. See the formulas in the above section for details. Calculating free cash flow from net income depends on the type of FCF.