What Is Unlevered Free Cash Flow (UFCF)?

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The unlevered free cash flow is of interest to investors and shareholders who use these numbers from a company’s financial statement to determine discounted cash flow (DCF) or future returns on their present investments. UFCF, in contrast to levered free cash flow (LFCF), is the cash left with the company post deducting interest payments and other financial obligations.

Key Takeaways

  • Unlevered free cash flow is the cash flow generated from business operations or investments post payment of taxes and accounting for working capital expenses.In contrast to unlevered cash flow, the levered flow accounts for the debt obligation of an organization, such as its interest and loan payments and dividends for shareholders.The EBITDA or earnings before the interest payments, taxes, depreciation, and amortization is first calculated to determine a firm’s unlevered cash flow.UFCF is of interest to investors and lenders, and thus it is used in determining the discounted cash flow.

Unlevered Free Cash Flow Explained

Unlevered free cash flow definition explains the gross earnings generated by a company from its core and non-core business operations that is not accountable for loan servicing. Moreover, it represents free cash flow from operations available to make payments to all stakeholders, including employees, vendors, interest and loan payments, dividends, etc.

The unlevered cash flow, also known as the Free Cash Flow of the Firm (FCFF), is available to all the equity and debt holders of a company post the deduction of operating expenses, capital expenditures, and required working capital. Later, the determination and accounting for other financial payments, such as interest, dividends, salaries, etc., are charges on levered cash flows.

The levered cash flow explains the cash flow situation of a business that carries out its operations through borrowings and thus attracts interest payments. As a result, the business will charge these payments on the cash flows generated from its business operations.

Similarly, a business may prefer UFCF to account for and determine the discounted cash flow. Again, it is because the future earnings from current investments and business operations should reflect higher cash flows for its investors. Thus, it will help retain the investors as they continue to receive higher returns on costs incurred and also attract potential investors.

Additionally, viewing UFCF separately from levered cash flows leads to ignorance of a well-designed capital structure to save overall cash flows. However, there are certain limitations to accounting and using UFCF for business valuation.

For instance, some businesses might not focus on improving core, revenue-generating business operations but rather beat around the bush to increase their cashflows in financial statements. It might involve letting go of employees to save on salaries, reduce inventory size, avoid capital investments, or source cheap and poor-quality raw materials to save on operations costs.

Formula

To demonstrate, the formula to calculate unlevered free cash flow involves,

UFCF = EBITDA – (T + CE + Increase in Non–Cash Working Capital) + Depreciation and Amortization

Where,

  • EBITDA = is Earnings before Interest Payments, Taxes, Depreciation, and AmortizationT = is Tax PaymentsCE = is Capital Expenditure to be incurred (cost of machines, buildings, and heavy equipment)

Calculation

Let us look at the application of the UFCF formula and understand its calculation,

Thus, the unlevered free cash flow formula includes the conversion of EBITDA to unlevered free cash flow by deducting any capital expenditures, taxes, and expenditures incurred for non-cash working capital (NWC). Specifically, NWC includes a company’s inventory, raw materials, finished goods, and other goods and services that assist it in business operations.

At the same time, adding non-cash expenditures such as depreciation and amortization is necessary to determine a company’s unlevered cash flow.

Example

Let us look at an example of unlevered cash flow and consider the same calculation from above to see what its implications are,

Firstly, to calculate the UFCF, the EBIT (earnings before interest and taxes) is calculated from the firm’s total earnings or cash flow. So, for example, the EBIT of Firm A is $10,000, and for Firm D, it is $18,000.

However, the resultant calculated EBITs of Firm A and Firm D may or may not be their target EBIT or EBITDA.

Thus, as seen in the case of Firm D, a higher EBIT or EBITDA allows a firm to have a higher resultant UFCF. In addition, a higher EBIT of Firm D gives it a positive UFCF or unlevered cash flow. Whereas Firm A, with a lower EBIT, has a negative unlevered cash flow situation.

Further, a negative cash flow of Firms A, B, and C also repels the investors from investing in a company as it reflects a poor capacity to service debt or expand its business operations through debt.

Thus, a higher unlevered cash flow post payment of taxes, incurring non-cash working capital, and capital expenditure will allow a firm to smoothly service its debt obligations in case of an existing loan or future loans. Thus, a firm with negative or low unlevered cash flow should strive to achieve EBITDA targets as soon as possible. Likewise, flexible and higher unlevered cash flows will allow firms A and D to expand their operations and business ventures by leveraging additional debt or borrowings.

Levered vs Unlevered Free Cash Flow

Unlevered cash flow is the amount of cash flow generated from business operations. It excludes taxes, capital expenditures, and changes in non-cash working capital. On the other hand, levered cash flow accounts for interest and loan payments, dividends, or other such payments that service a company’s debt.

UFCF reflects how a company uses its capital assets to generate cash flows. However, companies with a large debt burden prefer showing their UFCF to attract investors and lenders.

However, before investing and lending, it is important to realize for these stakeholders the difference between a company’s levered and unlevered cash flows as it reflects its ability to pay equity or debt financing obligations.

Another difference between unlevered and levered cash flows is the risk it poses to a company. For instance, a low UFCF is not extremely concerning as it reflects that either the company had no debt obligations or could not afford a debt.

However, if the levered cash flow of a company is low and UFCF is high, it reflects that a company has a significant amount of debt to service. Therefore, it is a matter of concern because if there is a slight decrease in the company’s revenues, it can face financial troubles.

This article has been a guide to What is Unlevered Free Cash Flow (UFCF). We explain its formula, calculation, example, and comparison with levered free cash flow. You may also find some useful articles here:

A company or firm may use unlevered cash flows to account for its total earnings or cash flow post payment of taxes, incurring capital expenditures, and working capital expenses. In addition, the UFCF allows a firm to determine its levered cash flow from which it makes interest payments or services its debt.

Unlevered cash flow allows a firm to account for its debt and financial payments post-payment of all the taxes. It is an indicator for the investors and lenders of the ability of the company to pay its debt obligations post payment of taxes.

UFCF is used to measure the dcf or the discounted cash flow as it helps a company or investors determine the expected future cash flows from current investments. Thus, it uses UFCF to realize actual future cash flow that generates from current investments post payment of taxes, incurring working capital expenditures and capital expenditures.

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