What is Unlevered Free Cash Flow & How Is it Calculated?

Unlevered free cash flow (UFCF) is an essential financial metric that provides investors and analysts with a clear picture of a company’s ability to generate cash before accounting for financial obligations such as debt repayments. For those looking to evaluate the core operations of a business without the distortions of its capital structure, unlevered free cash flow is a key tool. In this blog, we'll dive into what unlevered free cash flow is, how it's calculated, its importance in financial analysis, and how it differs from levered free cash flow.

What is Unlevered Free Cash Flow (UFCF)?

Unlevered free cash flow (UFCF), also known as free cash flow to the firm (FCFF), refers to the amount of cash a company generates from its operations that is available to all stakeholders, including both debt and equity holders. It is called "unlevered" because it ignores the capital structure of the company, meaning it does not account for interest payments or debt repayments. By focusing purely on operational cash flow, UFCF gives analysts and investors a clearer view of the company's core ability to generate cash.

For businesses, UFCF is an essential measure because it reflects the cash flow available for distribution to investors, acquisition opportunities, or reinvestment in the business itself, without the influence of the company’s financing structure.

Key Characteristics of UFCF:

• It represents the cash generated before paying interest on debts.
• UFCF assumes the company operates without debt, so it doesn’t consider the company’s financial leverage.
• It’s primarily used to assess a company’s performance, excluding its debt and financial obligations.

By focusing on UFCF, analysts can evaluate the company's performance independent of the financing decisions made by management. This allows for comparison across companies with different capital structures and provides a clearer understanding of operational efficiency.

How to Calculate Unlevered Free Cash Flow

The formula for calculating unlevered free cash flow requires several components from the company's financial statements, including the income statement and the balance sheet. Below is a step-by-step breakdown of the formula:

UFCF Formula:

UFCF = EBIT × (1−TaxRate) + Depreciation & Amortization − Change in Working Capital − Capital Expenditures 

Let’s break down the components:

1. EBIT (Earnings Before Interest and Taxes): This is the company’s operating profit, representing the earnings generated before accounting for interest expenses and taxes. EBIT is often referred to as operating income.
2. Tax Rate: This is the corporate tax rate that the company pays on its profits. The effective tax rate is applied to the EBIT to calculate the tax-adjusted operating income.
3. Depreciation & Amortization (D&A): These non-cash expenses are added back because they reduce net income but do not represent actual cash outflows.
4. Change in Working Capital: This refers to the changes in current assets and current liabilities. An increase in working capital reduces cash flow, while a decrease in working capital increases cash flow.
5. Capital Expenditures (CapEx): These are investments the company makes in its long-term assets such as property, equipment, and technology. CapEx represents cash outflows for maintaining or expanding the company’s asset base.

Example UFCF Calculation:

Assume a company has the following financial metrics:

• EBIT: $200 million
• Tax rate: 25%
• Depreciation & Amortization: $50 million
• Change in working capital: $10 million increase
• Capital Expenditures: $40 million

The UFCF calculation would look like this:

UFCF = (200 × (1−0.25)) + 50 − 10 − 40

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UFCF = (200 × 0.75) + 50−10 − 40

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UFCF = 150 + 50−10−40 = 150 million

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In this example, the unlevered free cash flow is $150 million. This represents the amount of cash the company generates from its operations before taking into account any debt-related obligations.

Importance of Unlevered Free Cash Flow

Unlevered free cash flow is a vital metric for several reasons:

1. Valuation and Discounted Cash Flow (DCF) Analysis

UFCF is commonly used in Discounted Cash Flow (DCF) analysis to estimate the intrinsic value of a company. Since UFCF is independent of the company’s capital structure, it allows analysts to project future cash flows without considering the financing strategy (i.e., the company’s mix of debt and equity). By discounting UFCF at the company’s weighted average cost of capital (WACC), analysts can derive the total enterprise value of the firm.

2. Comparison Across Companies

Because unlevered free cash flow ignores interest payments and financing decisions, it allows for better comparisons across companies that may have different levels of debt. For example, if two companies in the same industry have different capital structures, UFCF provides a clearer picture of which company is more efficient at generating cash from its operations.

3. Measuring Operational Efficiency

UFCF offers a pure reflection of a company’s ability to generate cash through its core business operations. Investors can use it to gauge how well management is running the business and whether the company has the potential to reinvest in growth or return capital to shareholders.

Levered vs Unlevered Free Cash Flow

While unlevered free cash flow (UFCF) excludes the impact of interest payments and focuses on operational cash flow, levered free cash flow (LFCF) includes interest payments and represents the cash flow available to equity holders after accounting for debt obligations.

Key Differences Between UFCF and LFCF:

1. Impact of Debt:some text
   • UFCF: Excludes interest payments and debt repayments. It assumes no debt and is used to evaluate the company’s overall cash-generating ability.
   • LFCF: Includes interest payments and debt repayments, making it a more accurate measure of the cash available to equity holders after fulfilling debt obligations.
2. Application:some text
   • UFCF is used in enterprise-level valuations, including mergers and acquisitions (M&A), as it considers the cash available to all capital holders (debt and equity).
   • LFCF is more relevant for equity valuation, as it shows the cash left for equity holders after the company meets its debt obligations.
3. Risk Consideration:some text
   • UFCF disregards the risks associated with debt financing, while LFCF considers these risks by including debt payments, offering a more comprehensive view of the cash left for equity holders.

Conclusion

Unlevered free cash flow is a critical financial metric that provides a clearer picture of a company's operational performance, without the influence of its capital structure. By calculating UFCF, investors and analysts can better understand a company’s ability to generate cash from its core operations, making it an invaluable tool for valuation, operational analysis, and financial comparisons.

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