What it means
A company can fund itself with its owners' money, with borrowed money or with a mix of both. Interest on debt reduces the cash available to owners, so two identical businesses with different debt levels will show different cash after interest.
Unlevered free cash flow removes this effect by ignoring financing, and focuses on the performance of the operations alone. It starts from operating profit and makes adjustments for taxes, non-cash items and investment.
First, tax is applied to operating profit as if the company had no debt, which gives net operating profit after tax (NOPAT). Then depreciation and amortisation, which are non-cash charges that reduce profit without using cash, are added back, and capital expenditure and the increase in working capital are subtracted.
Capital expenditure is the money spent on long-lasting assets such as machinery and buildings. Working capital is the money tied up in day-to-day operations, such as stock and customer invoices not yet paid, net of what is owed to suppliers.
Growth in either uses cash, so a fast-growing business can report profit and still have little free cash. UFCF is the standard input in a discounted cash flow (DCF) valuation.
Analysts forecast it for several years, discount it back to today at the weighted average cost of capital, and add a terminal value for the years beyond the forecast. The result is an estimate of the value of the whole business, before deducting debt to arrive at the value to shareholders.
There are variations in how it is calculated. Some analysts start from earnings before interest and tax, others from net income and add back after-tax interest, and treatment of items such as stock-based pay and leases differs.
The method should be stated clearly, and the same definition should be used for every company being compared. The measure is useful inside the company as well as in valuation.
A finance team can use it to judge whether a business unit pays for its own investment, or whether it relies on cash from elsewhere. It also helps in lending decisions, because lenders want to know whether operating cash flow comfortably covers the interest and repayments on a loan.
In practice
Real-world examples.
Example
An analyst values a logistics company by forecasting UFCF of $1,200,000 growing steadily, then discounting those cash flows. Because the measure ignores debt, she can compare it fairly with a competitor that has far less borrowing.
Example
A private equity team considers buying a manufacturer for $18,000,000. It uses UFCF to test whether the business can support the debt needed for the purchase, by comparing annual cash flow with expected loan payments.
Example
A chief financial officer reviews a fast-growing subscription business that reports a profit but has negative UFCF because of heavy investment in equipment and receivables. She tells the board that growth is consuming cash and that funding must be arranged.
Formula
Calculation
UFCF = EBIT x (1 - tax rate) + depreciation and amortisation - capital expenditure - increase in net working capital
A company has earnings before interest and tax (EBIT) of $2,000,000 and pays tax at 25%. NOPAT = 2,000,000 x (1 - 0.25) = $1,500,000. Depreciation and amortisation are $400,000, capital expenditure is $600,000, and net working capital rises by $100,000. UFCF = 1,500,000 + 400,000 - 600,000 - 100,000 = $1,200,000.Case study
Seen in the real world.
Tallis Packaging is an illustrative, fictional company with EBIT of $3,000,000 and a debt-heavy balance sheet. Its owner wanted to sell and believed that high interest costs made the business look unattractive.
An adviser calculated UFCF instead of looking at net income. With tax of 25%, NOPAT was $2,250,000, and after adding $500,000 of depreciation and deducting $700,000 of capital expenditure and $150,000 of extra working capital, UFCF was $1,900,000.
Buyers could then value the operations independent of the existing debt, and the company attracted offers based on its cash generation. The illustrative lesson is that UFCF shows what the business itself earns, which helps buyers compare companies that finance themselves differently. Several bidders also used the figure to test how much debt the company could carry after a purchase, which made the sale process faster.
Watch out
Common mistakes.
- Subtracting interest payments, when unlevered free cash flow is calculated before financing costs.
- Forgetting to add back depreciation, which is a non-cash charge that reduced profit without using cash.
- Ignoring working capital, so growth that ties up cash in stock and receivables is overlooked.
Questions
People also ask.
What is the difference between unlevered and levered free cash flow?
Unlevered cash flow is before interest and debt repayments, while levered cash flow is after them and shows what is left for shareholders.
Why do valuations use the unlevered version?
It values the operations independently of how they are financed, so the result can be discounted at the cost of capital and compared across companies.
Can UFCF be negative?
Yes, a growing business that invests heavily can have negative UFCF even when it reports an accounting profit.
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