Levered free cash flow

What Is Levered Free Cash Flow?

Levered free cash flow is the amount of cash a company has remaining after paying all its operating expenses, making necessary capital expenditures, and fulfilling its debt obligations, including both interest and principal repayments. This metric falls under the broader umbrella of Corporate Finance and Financial Analysis, offering a direct view of the cash available to equity holders. Unlike other cash flow measures, levered free cash flow explicitly accounts for the impact of a company's debt financing on its liquidity, making it a critical indicator for assessing the cash available for distributions to shareholders, such as through dividends or share repurchases.

History and Origin

The concept of free cash flow, in its various forms, evolved as financial analysts sought a more robust measure of a company's true financial health and capacity to generate wealth beyond traditional accounting profits like net income. While the idea of cash flow available after operating needs is foundational, the explicit distinction between "levered" and "unlevered" forms became more pronounced with the widespread adoption of discounted cash flow models for business valuation. Prominent finance academics and practitioners, such as Aswath Damodaran, have extensively detailed the nuances of free cash flow, including its application in valuation and the implications of a company's capital structure on cash flows available to different claimants. Damodaran has noted that while free cash flow is theoretically a superior measure for intrinsic valuation, a single year's free cash flow, whether to equity or the firm, can be volatile and less informative about operating health than earnings for pricing purposes.⁸

Key Takeaways

• Levered free cash flow represents the cash remaining for equity holders after all expenses and debt obligations are met.
• It provides insight into a company's ability to pay dividends, repurchase shares, or reduce debt.
• This metric is directly affected by a company's financing decisions, particularly its reliance on debt.
• Positive levered free cash flow indicates a strong capacity to generate cash after covering all operational and financial commitments.
• Analysts use levered free cash flow to assess a company's financial flexibility and its potential for shareholder distributions.

Formula and Calculation

Levered free cash flow can be calculated using various approaches, typically starting from a company's net income or operating cash flow, and then adjusting for non-cash items, capital expenditures, and crucially, net debt payments.

A common formula for levered free cash flow is:

Alternatively, starting from Free Cash Flow to Firm (unlevered free cash flow), levered free cash flow can be derived as:

Where:

• Net Income: The company's profit after all expenses, including taxes and interest, have been deducted.
• Depreciation & Amortization: Non-cash expenses added back as they do not represent actual cash outflows.
• Capital Expenditures: Cash spent on acquiring or upgrading physical assets like property, plant, and equipment.
• Change in Working Capital: The net change in current assets and current liabilities, indicating cash tied up in or released from operations.
• Mandatory Debt Principal Payments: The scheduled repayments of debt principal.
• Free Cash Flow to Firm: Cash generated by a company's operations before any debt payments, available to both debt and equity holders.
• Interest Expense: The cost of borrowing money.
• Tax Rate: The company's effective tax rate.
• Net Debt Issued/Repaid: The net cash flow from debt transactions (new debt issued minus debt repaid).

It is important to note that free cash flow is a non-GAAP (Generally Accepted Accounting Principles) measure, meaning there are no strict regulatory standards for its calculation, leading to variations in how it is presented.⁷,

Interpreting the Levered Free Cash Flow

Interpreting levered free cash flow involves understanding its implications for a company's financial health and its capacity to generate shareholder returns. A consistently positive and growing levered free cash flow indicates that a company is generating sufficient cash from its core operations to cover its investments in growth and its debt obligations, with a surplus available for its shareholders. This surplus can be used for dividends, share buybacks, or further debt reduction beyond mandatory payments. Conversely, a negative levered free cash flow means the company is not generating enough cash to meet its operational, investment, and debt servicing needs, potentially requiring additional financing, asset sales, or cuts to operations. This analysis provides valuable context often not immediately apparent from a company's financial statements alone.

Hypothetical Example

Consider "TechInnovate Inc.," a software company, reporting its financial results.

For the fiscal year, TechInnovate reports the following:

• Net Income: $50 million
• Depreciation & Amortization: $10 million
• Capital Expenditures: $15 million
• Change in Working Capital (increase, cash outflow): $5 million
• Mandatory Debt Principal Payments: $8 million

To calculate TechInnovate Inc.'s levered free cash flow:

Levered Free Cash Flow = Net Income + Depreciation & Amortization - Capital Expenditures - Change in Working Capital - Mandatory Debt Principal Payments
Levered Free Cash Flow = $50M + $10M - $15M - $5M - $8M
Levered Free Cash Flow = $32 million

In this scenario, TechInnovate Inc. has $32 million in levered free cash flow. This means that after covering its operational costs, investing in new assets, and meeting its debt obligations, the company has $32 million available to distribute to its equity investors or retain for other discretionary uses. This positive cash flow after all commitments signals a healthy financial position and flexibility.

Practical Applications

Levered free cash flow is a vital metric in various financial applications, offering insights into a company's true financial viability and capacity to return value to shareholders.

• Equity Valuation: Investors and analysts frequently use levered free cash flow in discounted cash flow models to estimate the intrinsic value of a company's equity. By projecting future levered free cash flows and discounting them back to the present using the cost of equity, analysts can arrive at a per-share valuation.
• Dividend Capacity and Share Buybacks: A strong and consistent levered free cash flow indicates a company's ability to sustain or increase dividends and execute share repurchase programs, directly benefiting shareholders.
• Credit Analysis: Lenders and bondholders analyze levered free cash flow to assess a company's capacity to meet its debt obligations, including interest and principal payments, which is crucial for evaluating creditworthiness.
• Mergers and Acquisitions (M&A): In M&A deals, potential acquirers use levered free cash flow to understand the cash generation potential for equity investors post-acquisition, especially if the deal involves significant new debt.
• Financial Health Assessment: Management uses levered free cash flow to monitor internal liquidity, make strategic decisions regarding capital allocation, and ensure the business can operate and grow without external financial distress. Public companies often report comprehensive financial data, including statements from which levered free cash flow can be derived, in their annual filings with regulatory bodies like the U.S. Securities and Exchange Commission (SEC). For example, a company's 10-K filing provides the detailed financial statements necessary for such analysis.⁶,⁵

Limitations and Criticisms

While levered free cash flow provides valuable insights, it is important to acknowledge its limitations and potential criticisms.

• Volatility: Levered free cash flow can be highly volatile from year to year, especially for companies with irregular capital expenditures or significant debt refinancing activities. This lumpiness can make it challenging to use a single year's figure as a reliable indicator of long-term performance. Professor Aswath Damodaran has highlighted that a single year's free cash flow can have more noise and be less informative about a company's operating health than its earnings.⁴
• Discretionary Payments: The calculation often includes only mandatory debt principal payments. However, companies may make discretionary debt repayments, which are not captured but still reduce cash available to equity holders.
• Manipulation Potential: Although generally considered less susceptible to accounting manipulation than net income, certain accounting policies, particularly those related to capital expenditures or working capital management, can influence the reported levered free cash flow.
• Comparison Difficulties: Comparing levered free cash flow across companies with vastly different capital structure can be misleading. Companies with high leverage will inherently have lower levered free cash flow due to higher debt service requirements, even if their underlying operational performance is strong. This is one reason why unlevered free cash flow is often preferred for peer comparisons. The Modigliani-Miller theorem, though operating under idealized conditions, provides a theoretical backdrop by suggesting that in the absence of market imperfections, a firm's value is independent of its capital structure. However, in the real world, factors like taxes and bankruptcy costs make capital structure and thus levered cash flows relevant., Research has indicated that the theoretical irrelevance proposed by Modigliani and Miller does not fully hold in practice, particularly for entities like banks, where capital requirements and associated costs impact lending.³

Levered Free Cash Flow vs. Unlevered Free Cash Flow

The primary distinction between levered free cash flow and unlevered free cash flow lies in how they account for a company's debt.

• Unlevered Free Cash Flow (UFCF), also known as Free Cash Flow to Firm (FCFF), represents the total cash flow generated by a company's operations before any debt payments (interest and principal) or the impact of debt financing are considered. It is the cash available to all capital providers—both bondholders and shareholders. UFCF is often preferred for valuation purposes when using the weighted average cost of capital (WACC) as the discount rate, as it provides a clearer picture of the operating assets' inherent cash-generating ability, irrespective of the capital structure.
• Levered Free Cash Flow (LFCF), on the other hand, measures the cash flow remaining after all debt obligations, including interest payments and mandatory principal repayments, have been satisfied. This metric specifically represents the cash available to equity financing providers (shareholders). Therefore, LFCF is more directly relevant to equity investors interested in a company's capacity for dividends or share buybacks.

The choice between using levered or unlevered free cash flow depends on the specific analytical objective. For comparing companies with diverse capital structures or when performing enterprise valuation, unlevered free cash flow is generally more suitable. However, for an equity investor focusing on distributions to shareholders, levered free cash flow provides a more direct and relevant measure.,

²## FAQs

How does levered free cash flow relate to a company's ability to pay dividends?

Levered free cash flow directly indicates the cash a company has available to distribute to its shareholders in the form of dividends. A consistent surplus in levered free cash flow suggests the company has the financial capacity to pay and potentially increase dividends.

Why is it called "levered"?

The term "levered" refers to the impact of financial leverage, or debt, on the cash flow. Levered free cash flow is calculated after accounting for interest expenses and principal repayments on debt, thereby reflecting the effect of the company's borrowing on the cash available to equity holders.

Can levered free cash flow be negative?

Yes, levered free cash flow can be negative. A negative figure indicates that a company's cash flow from operations, after accounting for capital expenditures and mandatory debt payments, is insufficient to cover its obligations. This often signals financial strain, potentially requiring the company to raise additional debt financing or equity financing, sell assets, or cut expenses.

Where can I find the information to calculate levered free cash flow?

The necessary financial data can typically be found in a company's public financial statements, specifically the cash flow statement and the balance sheet, filed with regulatory bodies like the SEC. Key line items include net income, depreciation and amortization, capital expenditures, changes in working capital, interest expense, and details of debt repayments.¹