Levered vs Unlevered Free Cash Flow: What’s the Difference?

Cash is king… but not every stakeholder sees cash the same way. For example, equity shareholders may want to know how much cash is available after paying loans and interest, whereas debt stakeholders want to know how much cash is available before loans and interest. These diverging needs for stakeholders has given birth to Free Cash Flow.

Free cash flow (FCF) is a term applied to the high-level calculation of cash available to stakeholders of a company. It comes in 3 common forms:

  • Simple Free Cash Flow
  • Unlevered Free Cash Flow
  • Levered Free Cash Flow

The differentiator between these metrics is the way they treat debt. When debt principle payments and interest are included in the calculation, FCF is said to be levered. When interest expenses and principle are excluded, FCF is said to be unlevered. The nuance is that when FCF includes interest expense but excludes principle payments, it’s called simple free cash flow.

Free Cash Flow (FCF) includes interest expenses but excludes debt principle payments.
Unlevered Free Cash Flow (UFCF) excludes interest expense and debt principle payments.
Levered Free Cash Flow (LFCF) includes both interest expenses and debt principle payments.

If this isn’t clear yet, don’t worry. In this article I will cover everything from how to calculate each type of FCF and their formulas, down to simple FAQs. For a deeper dive into Free Cash Flow and when to use it, sign up to pre-order our Free Cash Flow Cheat Sheet:

Difference Between Levered and Unlevered Free Cash Flow

Before we get into the details, let’s succinctly answer the question you came here for:

The difference between levered and unlevered FCF is that levered free cash flow (LFCF) subtracts debt and interest from total cash, whereas unlevered free cash flow (UFCF) leaves it in, such that LFCF = Net Profit + D&A – ΔNWC – CAPEX – Debt, and UFCF = EBIT*(1-tax rate) + D&A – ΔNWC – CAPEX.

NOTE: you may sometimes see LFCF calculated as LFCF = EBITDA – ΔNWC – CAPEX – Debt. The problem with this calculation is that starting with EBITDA does not account for taxes paid. Since the purpose of LFCF is to determine cash available to equity holders, and taxes reduce the amount available to them, it’s best to start with net profit as shown above. However, in practice you will see the EBITDA formula used because its easier and faster.

What is free cash flow?

As a concept, free cash flow is the amount of cash available from the operations of the company, as derived from the income statement (i.e Net Income + D&A – Δ net non-cash working capital), minus any capital expenditures paid in the period. You can also take cash flow from operations from the cash flow statement as the starting point, as we’ll see in the formulas section below.

Is free cash flow levered or unlevered?

A common confusion is assuming free cash flow is binary: either (1) levered or (2) unlevered. In reality, there’s a 3rd option. Simple Free Cash Flow as such is an independent metric that includes interest expenses but excludes debt payments. In this sense, it’s partially levered and partially unlevered.

Simple Free Cash Flow is the basis for calculating levered and unlevered free cash flow, so we need to understand it well.

Why is free cash flow important?

Free Cash Flow is important because it’s remarkably easy to calculate and can be quickly used as the basis for a valuation scenario.

If a private equity firm wants to quickly decide on a minor investment in its portfolio, they may default to a simple DCF model using Free Cash Flow.

Why? Because as you’ll see, unlevered and levered cash flows require more time and information to create. In some cases they’re necessary, but in many the simple FCF will meet the needs of decision makers.

What does simple free cash flow indicate?

FCF indicates the amount of cash available to a company after paying CAPEX and operational expenses — including interest — but BEFORE paying debt principle payments.

Unlevered Free Cash Flow a.k.a free cash flow to the firm (FCFF)

Unlevered Free Cash Flow is also known as Free Cash Flow to the Firm (FCFF). Why does it bear this name? The idea is that unlevered free cash flow excludes all impacts of debt on cash flow, including interest and the tax benefits of interest expense. The firm, therefore, has a theoretical cash flow in the case it had no debt — its free cash flow.

We can therefore calculate FCFF by starting with earning before interest and tax (EBIT). Since we want to eliminate the impact of interest on tax payment, we will simply calculate the taxes due on this amount. We call the result of this calculation NOPAT — net operating profit after tax.

Thereafter, we need to add back non-cash items such as depreciation and amortization, then subtract increases or add decreases in net non-cash working capital from the balance sheet. Moreover, we need to subtract capital expenditures for the period. The final value is our FCFF.

For clarity’s sake, you can also think of FCFF as Cash Flow from Operations (CFO) + Interest – Interest*(tax rate) – CAPEX. The Interest*(tax rate) is called a tax shield and is used to reduce the tax benefit of interest expense that’s included in CFO — we used interest in CFO to reduce taxable income and need to reverse that benefit.

A Note on Tax Shields

Tax shields can be tough to conceptualize. The best way to think about them is in relation to the role of interest.

Net Income used in Cash Flow from Operations includes interest expense. The inclusion of this expense lowers taxable income. When we add interest expense back, we need to remove this benefit from the bottom line. To remove it, we calculate the tax rate*interest and subtract this from cash flow. If not, we would have artificially-low taxes paid.

Levered Free Cash Flow a.k.a Free Cash Flow to Equity (FCFE)

Levered free cash flow is also known as free cash flow to equity (FCFE). Why does it bear this name? 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. Another way of doing this is to start with net profit and simply add back D&A, +/- ΔNWC, and subtract debt.

As mentioned earlier, you will sometimes see levered free cash flow calculated using EBITDA, then subtracting CAPEX, ∆NWC, and debt. This is not ideal because it ignores the impact of interest on free cash flow, and we want to include it’s impact.

How is free cash flow calculated? Levered and Unlevered

Now that we’ve explored how to think about levered and unlevered free cash flow, let’s look at different formulas for calculating them and answer common questions.

Free Cash Flow Formula

The simple Free Cash Flow formula is Net Income + D&A – ∆NWC – CAPEX.

Levered Free Cash Flow Formulas

The formulas for Levered Free Cash Flow, or Free Cash Flow to Equity are:

  • Net Income + D&A – ∆NWC – CAPEX – Debt (best)
  • Cash Flow from Operations – CAPEX – Debt (best if cash flow statement available)
  • EBITDA – ∆NWC – CAPEX – Debt (this one is common, but not correct because it excludes the impact of interest by starting with EBITDA)
  • EBIT*(1-tax rate) – Interest + Interest*(tax rate) + D&A – ∆NWC – CAPEX – Debt (similar to unlevered free cash flow but doesn’t include tax shield for interest and does includes Debt).

Unlevered Free Cash Flow Formulas

The formulas for Unlevered Free Cash Flow, or Free Cash Flow to the Firm are:

  • EBIT*(1-tax rate) + D&A – ∆NWC – CAPEX (best and most common)
  • Cash Flow from Operations + Interest – Interest*(tax rate) – CAPEX (uncommon and used mainly in cases where there is a lack of P&L information)
  • Net Income + Interest – Interest*(tax rate) + D&A – ∆NWC – CAPEX (uncommon and used mainly in cases of limited information)

Does Free Cash Flow include interest?

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.

Does Free Cash Flow include dividends?

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.

Does Free Cash Flow include depreciation?

None of the 3 types of free cash flow consider depreciation as a cash-reducing item because depreciation is non-cash.

Does Free Cash Flow include financing activities?

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.

How to Get Free Cash Flow from Financial Statements

To get free cash flow from the financial statements, you’ll need all three. Depending on the type of free cash flow, you’ll need to calculate items such as EBIT from the Income statement, ∆NWC from the balance sheet, and debt obligations and CAPEX from the cash flow statement. See the formulas in the above section for details.

Net Income to Free Cash Flow: Levered and Unlevered

Calculating free cash flow from net income depends on the type of FCF. Using Levered Free Cash Flow, the formula is [Net Income + D&A – ∆NWC – CAPEX – Debt]. Using Unlevered Free Cash Flow, the formula is [Net Income + Interest – Interest*(tax rate) + D&A – ∆NWC – CAPEX]. Using simple Free Cash Flow, the formula is [Net Income + D&A – ∆NWC – CAPEX].

Free Cash Flow from Cash Flow Statement: Levered and Unlevered

Calculating free cash flow from the cash flow statement also depends on the type of FCF. Using Levered Free Cash Flow, the formula is [Cash Flow from Operations – CAPEX – Debt]. Using Unlevered Free Cash Flow, the formula is [Cash Flow from Operations + Interest – Interest*(tax rate) – CAPEX]. Using simple free cash flow, the formula is [Cash Flow from Operations – CAPEX].

Free Cash Flow Yield: Levered and Unlevered

Free cash flow yield is a ratio wherein a FCF metric is the numerator and the total number of shares outstanding is the denominator. A company with debt will have a higher unlevered FCF yield than a levered FCF yield. FCF yield is also known as Free Cash Flow per Share.

S&P 500 Free Cash Flow: What is it?

How does FCF fit into the larger market? The S&P tracks Free Cash Flow Yield for all of the company’s in its index. This helps investors understand how cash performance of companies compares to price performance. While it may vary by source, the most common type of FCF used in the S&P Free Cash Flow is Simple Free Cash Flow [Net Income + D&A – ∆NWC – CAPEX].

Free Cash Flow Conversion: Levered and Unlevered

Cash flow Conversion is a simple ratio that compares Free Cash Flow to Net Income. It’s called “conversion” because it shows how much profit gets turned into cash. In most cases, cash conversion deals with total cash from operations on the cash flow statement. However, it can be done with levered and unlevered FCF.

As a general rule, the cash conversion ratio will be higher with unlevered FCF than with levered FCF.

Free Cash Flow Valuation Model: Levered and Unlevered

The basis for any company valuation is the cash it generates. However, absolute cash production is not reflective of the company’s value because it includes debt.

By way of metaphor, imagine you have a home that you bought for $100K and for which you have an $80K mortgage. You would not say the home is worth $20K ($100K – $80K). Instead you would say it’s worth $100K, since this is the value someone is willing to pay to purchase the home.

This is the concept of intrinsic value, and it applies to company valuations as well. In a sentence, the value of a company, like a home, is the cash flows it produces without the effect of debt.

You probably see where this is going. To calculate the value of a company using a discounted cash flow (DCF) model, we use unlevered free cash flow to determine its intrinsic value.

However, we also need to ensure the company has enough cash to pay down its debt obligations in an acquisition scenario. If not, the intrinsic value is not worth much because the company will be defunct.

When to Use Free Cash Flow Valuation

So, we know that valuations are based on unlevered free cash flows. But is this the only way to perform a valuation? The answer is no. Another way of determining value is through enterprise value (EV), which starts with market capitalization, then subtracts debt and adds cash.

If there are many ways of determining value, when should we use the unlevered free cash flow technique?

The answer is straightforward. You should use a DCF model based on unlevered free cash flows whenever information and time allow, and only use an alternative such as market cap -> EV if you lack data or time to execute the full model.

Free Cash Flow Margin: Levered and Unlevered

Free Cash Flow margin is a ratio in which FCF is the numerator and sales is the denominator. Margin tells us what portion of sales ends up as FCF. The margin will be higher for unlevered FCF than for levered if the company has any debt.

Financial Ratios

  • FCF/Enterprise Value. Tells what portion of enterprise value can be accounted for in one year’s FCF. This will be higher for unlevered FCF than for levered if the company has any debt.
  • FCF/Total Debt. Tells how well your FCF can pay for debt. Levered FCF is rarely used for this metric since its purpose is typically to determine if a loan or credit facility should be provided to the company, which requires unlevered FCF.
  • FCF/Operating Cash Flow. Tells how much more the sum of one or more of CAPEX + Interest + Debt is than operating cash flow, depending on which FCF metric is used.
  • FCF/Sales. A.k.a Free Cash Flow Margin, tells what amount of sales ends up as FCF in a given year.
  • FCF/Total Assets. Tells how well assets are generating FCF.
  • FCF/Current Liabilities. Tells how well FCF can cover obligations due within a year.
  • FCF/Net Income. A.k.a Free Cash Flow Conversion, tells what portion of of net income is “converted” into FCF. The number is higher for unlevered FCF than levered.

Conclusion

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