What it means
The word unlevered simply means before the effects of borrowing. You start with operating profit, deduct tax as though the company had no debt at all, add back depreciation and amortisation because they are not cash costs, then subtract capital spending and any increase in working capital.
What remains is the cash available to everyone who funded the business, lenders and shareholders alike. This is the figure at the heart of a discounted cash flow valuation.
Because it is financing neutral, an analyst can value the whole enterprise first and then decide separately how that value splits between debt holders and equity holders. It also makes acquisition maths cleaner.
A buyer who intends to repay the target's existing loans on completion day does not care what interest the current owners pay, only what the operations throw off, and this measure answers precisely that question. The tax line is the most common source of argument.
Unlevered free cash flow applies a notional tax charge to operating profit and ignores the tax saving that interest payments genuinely create, on the basis that the saving is handled separately inside the discount rate. Levered free cash flow is the sibling measure, calculated after interest and debt repayments, and it shows what is actually available to shareholders.
Neither one is better; they answer different questions, so always check which version a spreadsheet is using before comparing it with anything else.
In practice
Real-world examples.
Example
A private equity buyer builds a model of a logistics business carrying $40,000,000 of existing debt. It values the company on unlevered free cash flow because it intends to repay those loans at completion and refinance with its own borrowing structure.
Example
Two software firms each generate $8,000,000 of unlevered free cash flow, but one is debt free while the other pays $3,000,000 of interest a year. Their enterprise values come out similar and their equity values come out very different, which is exactly what the unlevered measure is designed to show.
Example
A CFO presenting a five year plan is asked to strip out interest so the board can see whether the operating business funds its own capital expenditure. Unlevered free cash flow turns negative in year two because a new plant is being built, which prompts a useful debate about phasing rather than about the loan.
Think of it
“Unlevered free cash flow is total cash the business generates for everyone-lenders and owners combined.
Formula
Calculation
Unlevered free cash flow = EBIT x (1 - tax rate) + depreciation and amortisation - capital expenditure - increase in working capital
A packaging manufacturer reports EBIT, meaning earnings before interest and tax, of $4,000,000 and faces a 25% tax rate. Notional tax is $4,000,000 x 0.25 = $1,000,000, so after tax operating profit is $4,000,000 - $1,000,000 = $3,000,000.
Depreciation and amortisation for the year were $600,000, capital expenditure was $900,000, and working capital rose by $200,000 as stock and receivables grew alongside sales.
Unlevered free cash flow = $3,000,000 + $600,000 - $900,000 - $200,000 = $2,500,000.
If the same business also paid $500,000 of interest and repaid $300,000 of principal during the year, its levered free cash flow would be lower, but the $2,500,000 is the number a buyer values before deciding how to finance the purchase.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Ravenscroft Ceramics, an invented mid sized tile maker, put itself up for sale and received two very different indicative offers. Its owners could not understand why one bidder valued the company 30% higher than the other when both had seen the same accounts.
The lower bidder had worked from net profit, which was heavily reduced by interest on a legacy family loan, while the higher bidder had rebuilt the numbers on an unlevered basis and found $2,500,000 of annual free cash flow before financing. Once Ravenscroft's fictional advisers presented the unlevered figures clearly, alongside a note that the family loan would be repaid at completion, the lower bidder revised its offer upwards.
The point of the illustration is not that one method is right and the other wrong. It is that the value of a business and the way it happens to be financed are two separate questions, and mixing them together produces confused negotiations.
Watch out
Common mistakes.
- Deducting interest when calculating unlevered free cash flow, which quietly turns it into the levered measure and makes debt heavy companies look worse than their operations deserve.
- Using the actual tax charge from the accounts rather than a notional tax on operating profit, which smuggles the interest tax shield into a figure meant to exclude financing entirely.
- Forgetting the working capital movement, so a business that is growing rapidly and absorbing cash into stock and receivables appears to generate more cash than it really does.
Questions
People also ask.
Why add back depreciation?
Because it is an accounting charge that spreads the cost of past spending rather than money leaving the bank this year, and current year spending is captured separately as capital expenditure.
Is unlevered free cash flow the same as EBITDA?
No, since EBITDA ignores tax, capital expenditure and working capital, all three of which are real cash items that this measure deducts.
Which measure should a small business owner track?
Levered free cash flow is usually more relevant day to day because it reflects the loan payments you actually make, while the unlevered version comes into its own when selling or refinancing.
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