Unlevered Free Cash Flow Definition and Formulas

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When you review your monthly household budget, you add up all regular sources of income, then subtract all regular expenses. You want to see income greater than expenses—that is, you want to have positive cash flow.

You also need to be aware of your borrowing: how much debt you incur, and your ability to repay that debt from your cash flow.

Businesses do this, too. They need to gauge their cash flow so they can pay all operating expenses, have enough left to run the business, and pay off any debts to lenders.

What is unlevered free cash flow?

Unlevered free cash flow is the money left from a company’s cash flow after making capital expenditures to maintain or improve the business’s assets, but before paying any interest costs for debt.

Unlevered means “without leverage,” because it doesn’t take into account the cost of any debt that may be used in operating a business. Debt is typically in the form of bonds or bank loans. So unlevered free cash flow is the amount of cash available for the business to use before subtracting interest expense on debt.

Companies can vary in their use of leverage, sometimes referred to as debt capital, versus reinvested earnings, or equity capital. Some companies may have no debt, relying only on their profits to fund operations and new business projects. Others might rely on debt for some percentage of their capital. The mix of a company’s debt and equity is called its capital structure.

How is unlevered free cash flow used?

By excluding leverage from free cash flow, analysts and investment managers can better compare companies. Otherwise, different capital structures with different amounts of debt interest would skew comparisons. For example, a debt-free company has no interest costs, while a company that relies on debt for 50% of its capital would have substantial interest expenses.

Unlevered free cash flow is preferred among investment professionals because they can perform valuation analyses of companies regardless of their capital structures. It also means they can broaden their valuation of a company beyond market capitalization by including a company’s debt as capital, a measure known as total enterprise value. Investors and businesses typically use enterprise value when considering a possible price for acquiring or selling a company.

Levered vs. unlevered: What’s the difference?

Interest expense accounts for the difference between unlevered and levered free cash flow. Unlevered free cash is before financing payments. Levered free cash is calculated after those payments, and therefore is a smaller amount than unlevered free cash flow.

Here are two parallel statements and their frequently used market terminology to help remember the difference between the two:

  1. Unlevered free cash flow = gross cash flow = free cash flow to firm (FCFF), before any interest payments on debt obligations.
  2. Levered free cash flow = net cash flow = free cash flow to equity (FCFE), after the company meets its debt obligations. The company can use this money to pay dividends to shareholders, buy back stock, or invest in a new business project.

A company that uses a lot of debt to finance its operations will have an incentive to tout its unlevered free cash flow as an indicator of its financial health. Investors may want to compare that against levered free cash flow to assess how much free cash flow is being used to pay interest expense. Highly leveraged companies are more at risk of defaulting on their debt obligations and filing for bankruptcy.

How to calculate unlevered free cash flow

There are a couple of ways to calculate unlevered free cash flow, depending on the financial data available on a company.

The common feature of all methods is they exclude depreciation and amortization, because these are non-cash charges. They also exclude interest expense, because unlevered free cash flow is before payment of interest on debt.

The easiest method is to start with net income. The other unlevered free cash flow formulas are more complicated because they start with numbers that require closer examination of the company’s financial statements, including its balance sheet and its statement of cash flows. The formulas are as follows:

1. Using net income: Net income + depreciation and amortization + interest expense - capital expenditures - change in net working capital

2. Using EBITDA: Earnings before interest, taxes, depreciation, and amortization (EBITDA) - capital expenditures - change in net working capital - taxes

3. Using EBIT: Earnings before interest and taxes (EBIT) x (1 - tax rate) + depreciation and amortization - capital expenditures - change in net working capital

Depreciation is a charge against profit for the estimated decline in the value of tangible, operating assets—think of a delivery truck that wears out with use. Amortization is a charge for the estimated decline in the value of intangible assets, such as patents and trademarks, copyrights, and goodwill from acquisitions—typically, the extra amount a buyer pays for another company’s brand name and reputation in addition to its net assets. Because these are noncash items, they are added back to derive cash flow.

Working capital is the value of current assets (inventory, accounts receivable, liquid securities) minus current liabilities (accounts payable, short-term debt, notes payable, taxes) on a company’s balance sheet. An increase in working capital from the previous year’s balance sheet signifies a net increase in current assets and thus a net cash outflow, because money was used to purchase the assets; a net decrease in working capital means less money was spent on current assets and thus a net cash inflow.

Example of unlevered free cash flow

Let’s use the hypothetical Widget Corp., with $75,000 in net income in its most recent year, and the following line items in its financial statements. Here’s how to calculate unlevered free cash flow.

Net income (from income statement) $75,000
Depreciation/amortization (income statement) + 5,000
Interest expense (income statement) +30,000
Capital expenditure (from balance sheet) -35,000
Net change in working capital (balance sheet) -10,000
Unlevered free cash flow $65,000

This makes it clear how much unlevered free cash flow a company has against its interest expense. In this case, Widget’s unlevered cash flow is more than two times its interest expense, indicating it’s able to meet its interest obligation with money to spare for dividends and stock buybacks, or investing in new business projects.

On the other hand, after subtracting the $30,000 interest expense, Widget’s levered free cash flow is $35,000. This gives a different perspective: almost half the company’s unlevered free cash is devoted to paying interest on debt. That leaves less for new business projects or to reward shareholders.

Unlevered free cash flow FAQ

Do you use levered or unlevered for DCF (discounted cash flow)?

Unlevered free cash flow is often preferred by investors because it removes the bias of capital structure from discounted cash flow calculations. It also allows for a more comprehensive valuation of a company, called enterprise value, which includes debt outstanding as well as the market value of its publicly traded shares. For example, a company with a $20 billion market value and $5 billion of bonds outstanding would have a $25 billion enterprise value.

Why do you use unlevered free cash flow for DCF?

Unlevered free cash flow allows for a fairer comparison between companies based on their discounted cash flows because it ignores their use of debt or equity. It also can produce a higher present value of discounted cash flows because it uses a lower discount rate, made up of a blend of the company’s interest rate on its debt and its rate of return on equity. This is called a company’s weighted average cost of capital (WACC).

When would you use levered free cash flow?

Investors can use levered free cash flows as a reality check against unlevered free cash flows to weigh a company’s ability to meet its financial obligations, such as interest payments to lenders and bondholders. For a company that pays dividends, comparing levered against unlevered free cash flow can show if it still has enough free cash to maintain those payments to shareholders.