Unlevered Free Cash Flow: What Is it and Why Is it Important?
By Vladana Donevski
June 19, 2023
Unlevered free cash flow is a term used in corporate finance and investment analysis to discern a company’s value. It is the amount of cash a company generates after deducting interest payments, income taxes, and other expenses.
This metric is important for business owners and investors alike, as it can be used to make informed decisions about a business or investment opportunity. So, let’s explore unlevered free cash flow in more detail and discuss how you can use it to assess a company or individual investment portfolio.
We’ll also look at some of the key considerations when assessing this metric and potential pitfalls associated with using it to assess the enterprise value of a business.
So, What Is Unlevered Free Cash Flow (UFCF)?
This type of free cash flow measures a company’s ability to generate cash flow from operations. It is calculated by subtracting a company’s interest payments and income tax payments from its operating cash flow.
This metric is often represented on the company’s financial statements, but analysts also calculate this enterprise value manually. Unlevered free cash flow is important for business owners and investors alike because a cash flow statement indicates a company’s ability to generate cash flow after meeting its financial obligations.
How Is Unlevered Cash Flow Calculated?
The unlevered free cash flow formula is:
Unlevered cash flow = operating cash flow – interest payments – income tax payments
The formula for calculating unlevered cash flow considers earnings before interest, taxes, depreciation, and amortization, which is known as EBITDA, and investments in buildings, equipment, or machines, also known as CAPEX. The math will also include inventory, accounts receivable, and accounts payable to calculate the net operating profit.
Levered vs Unlevered Free Cash Flow
When calculating free cash flow to find out how much capital your business could use for growth or whether a business is worth investing in, it’s important to differentiate between levered free cash flow and unlevered free cash flow.
Levered free cash flow measures a company’s ability to generate cash flow after meeting its financial obligations. This includes debt obligations, operating expenses, and capital expenditures.
On the other hand, unlevered free cash flow measures a company’s ability to generate cash flow from operations.
While both unlevered and levered free cash flow are important, the first is often used as a more accurate measure of a company’s true cash-generating potential. This is because it excludes the impact of debt on a company’s cash flow.
What Can Unlevered Free Cash Flow Tell Us About the Company?
Unlevered free cash flow can be used to make informed decisions about a business or investment opportunity by evaluating the company’s ability to generate cash flow.
Whether or not a company presents unlevered vs levered free cash flow on its income statement can make all the difference for investors. A company that is highly leveraged by debt may be more inclined to report unlevered flows on its cash flow statement. This way, the company ignores its debt and provides a less realistic and more positive overview of its working capital to its potential investors.
It’s advisable for investors to check the amount of debt weighing the company down before investing. In particular, they should seek information on the overall free cash flow margin and not rely solely on the numbers presented as unlevered free cash flow.
The difference between levered and unlevered can also be an important indicator of a company’s expenses, financial obligations, and the debt it might be in. Occasionally, the levered free cash flow could be negative – in this instance, the company owes more than it earns, which you wouldn’t be able to tell simply by looking at its unlevered free cash flow.
If the difference between unlevered and levered free cash flow is too small, this could also indicate that the company is barely getting by. When you calculate unlevered free cash flow and compare it to levered free cash flow, it’s an indicator that companies with a small difference between the two could easily go under if there’s a sudden drop in their revenue.
Potential Pitfalls of Using Free Cash Flow as an Analytical Tool
There are a few potential pitfalls associated with using unlevered free cash flow as an analytical tool. First, it is important to remember that the unlevered free cash flow formula does not take into account a company’s capital structure, and some companies may take advantage of this fact when presenting their financials. This means that a company with a high level of debt may appear to have a higher net present value than it actually does.
Furthermore, companies themselves can manipulate the unlevered free cash flow metric for their financial statement. For instance, a company could choose to defer or prepay certain expenses, such as loan payments, to make itself look better. It could also fire employees or postpone capital-intensive projects to tweak its unlevered free cash flow.
Bottom Line
Despite its pitfalls, unlevered free cash flow can be an excellent measure of a company’s ability to generate free cash flow after interest and taxes. It is important for business owners and investors alike, as it can be used to make informed decisions about a business or investment opportunity.
It can be used to assess the financial health of a company and the potential return on investment. However, there are some key considerations to keep in mind when assessing unlevered free cash flow, such as the projection period over which the cash flow is being generated and the company’s capital structure.
Altogether, when unlevered free cash flow working capital is combined with other metrics like levered free cash flow, it can be a great indicator of whether a company could be a good investment or not.
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