Unlevered free cash flow

What Is Unlevered Free Cash Flow?

Unlevered free cash flow (UFCF) represents the cash a company generates before accounting for any interest expense or other debt-related payments. It is a critical metric within financial analysis and valuation, as it reflects the cash flow available to all capital providers, including both equity and debt holders. This measure provides a view of a company's operational performance independent of its capital structure, making it particularly useful for comparing businesses with varying levels of financial leverage. Unlevered free cash flow differs from simpler cash flow measures by specifically stripping out the impact of financing decisions.

History and Origin

The concept of free cash flow, from which unlevered free cash flow derives, gained prominence in financial discourse as analysts sought a more comprehensive measure of a company's financial health than traditional accounting profits. The idea of "free cash flow" was notably put forth by Michael Jensen in 1986 within the context of agency problems, describing cash flow in excess of that required for all projects with positive net present values. While Jensen did not propose a specific calculation, his work laid foundational groundwork for the metric's development and subsequent widespread adoption in financial modeling⁴. Over time, practitioners and academics refined the definition to separate the cash generated by core operations from the effects of financing, leading to the clear articulation of unlevered free cash flow as a distinct and valuable metric.

Key Takeaways

• Unlevered free cash flow (UFCF) measures the cash generated by a business before considering debt obligations, making it capital structure-agnostic.
• UFCF is crucial for business valuation, particularly in discounted cash flow (DCF) models, as it allows for direct comparison across companies regardless of their financing mix.
• It represents the total cash available to all providers of capital (both equity and debt).
• Calculating unlevered free cash flow involves adjustments to net income for non-cash expenses, changes in working capital, and capital expenditures.
• Analysts use unlevered free cash flow to determine a company's inherent earning power and its enterprise value.

Formula and Calculation

Unlevered free cash flow can be calculated in several ways, typically starting from either Net Income or Earnings Before Interest and Taxes (EBIT), and adjusting for non-cash items and investment activities. A common formula is:

Where:

• EBIT (Earnings Before Interest and Taxes): A measure of a company's profitability from its operations.
• Tax Rate: The effective tax rate applicable to the company's operating income.
• Depreciation: The expensing of an asset over its useful life, a non-cash charge.
• Amortization: The expensing of intangible assets over their useful life, also a non-cash charge.
• Capital Expenditures: Funds used by a company to acquire, upgrade, and maintain physical assets.
• Change in Working Capital: The change in current assets less current liabilities, reflecting short-term operational cash needs.

This formula effectively derives the cash flow from operations before the effects of debt are considered, and then subtracts necessary investments in both long-term and short-term assets required to sustain and grow the business.

Interpreting the Unlevered Free Cash Flow

Interpreting unlevered free cash flow (UFCF) involves assessing a company's ability to generate cash from its core operations, independent of its financing structure. A consistently positive and growing unlevered free cash flow typically indicates a financially healthy company that can fund its operations, invest in growth, and service its obligations without relying excessively on external financing. For instance, a high UFCF suggests strong operational efficiency and pricing power, allowing the firm to retain a significant portion of its revenues after covering essential operating and investing needs.

Analysts often compare unlevered free cash flow across different periods for the same company to identify trends in operational performance. They also compare it with competitors to gauge relative efficiency and market position. Since UFCF removes the impact of debt, it offers a clearer "apples-to-apples" comparison between companies, regardless of their financial leverage. This metric is especially valuable in a discounted cash flow (DCF) model, where future UFCF projections are discounted to arrive at an intrinsic valuation of the firm.

Hypothetical Example

Consider "AlphaTech Inc.," a rapidly growing software company. For the fiscal year, AlphaTech reports:

• EBIT: $50 million
• Tax Rate: 25%
• Depreciation: $5 million
• Amortization: $2 million
• Capital Expenditures: $10 million
• Increase in Non-Cash Working Capital: $3 million

To calculate AlphaTech's unlevered free cash flow:

1. Calculate Net Operating Profit After Tax (NOPAT):
   $50 \text{ million} \times (1 - 0.25) = 50 \text{ million} \times 0.75 = $37.5 \text{ million}$

2. Add back Depreciation and Amortization:
   $37.5 \text{ million} + 5 \text{ million} + 2 \text{ million} = $44.5 \text{ million}$

3. Subtract Capital Expenditures:
   $44.5 \text{ million} - 10 \text{ million} = $34.5 \text{ million}$

4. Subtract Change in Working Capital:
   $34.5 \text{ million} - 3 \text{ million} = $31.5 \text{ million}$

Therefore, AlphaTech Inc.'s unlevered free cash flow for the year is $31.5 million. This figure represents the cash flow AlphaTech generated from its operations that is available to all its investors, before any considerations of its financing decisions or interest expense on its debt. This cash could be used to pay dividends to equity holders, service debt, or reinvest in the business, depending on management's strategic priorities.

Practical Applications

Unlevered free cash flow is a cornerstone in various aspects of finance and investing:

• Company Valuation: It is the primary input in discounted cash flow (DCF) models used to determine a company's enterprise value. By discounting future unlevered free cash flows at the weighted average cost of capital (WACC), analysts can estimate the intrinsic value of an entire firm, irrespective of its capital structure³. This approach is widely used in investment banking, private equity, and corporate development.
• Mergers and Acquisitions (M&A): In M&A deals, buyers often use unlevered free cash flow to assess the target company's standalone operational cash-generating ability. This allows for a consistent basis of comparison between potential targets, as it strips out the effects of existing financing that would be restructured post-acquisition.
• Credit Analysis: While unlevered free cash flow does not directly show a company's ability to cover its debt payments, credit analysts use it to understand the underlying operational strength and capacity to generate cash before debt servicing. This provides insight into the company's long-term sustainability and potential to take on or repay debt.
• Performance Evaluation: Management teams may track unlevered free cash flow as a key performance indicator (KPI) to understand the efficiency of their core business operations. It helps them focus on improving operational cash generation without the distortions of financing choices.
• Regulatory Reporting: Although not a GAAP (Generally Accepted Accounting Principles) measure, companies often provide reconciliations of free cash flow, including variants like unlevered free cash flow, in their filings with the U.S. Securities and Exchange Commission (SEC) to offer additional insights to investors².

Limitations and Criticisms

Despite its utility, unlevered free cash flow (UFCF) has several limitations that financial professionals and investors must consider:

• Non-GAAP Measure: Unlevered free cash flow is a non-GAAP financial measure, meaning there is no universally standardized definition or calculation methodology across companies or industries. This lack of standardization can make direct comparisons challenging and requires analysts to understand the specific adjustments each company makes when reporting or calculating its free cash flow¹.
• Sensitivity to Assumptions: In financial modeling, especially in discounted cash flow valuations, future projections of unlevered free cash flow are highly sensitive to underlying assumptions about revenue growth, profit margins, capital expenditures, and changes in working capital. Small changes in these assumptions can lead to significantly different valuation outcomes.
• Ignores Capital Structure's Reality: While ignoring capital structure is the strength of unlevered free cash flow for comparability, it also means it does not reflect the actual cash available to equity holders after debt obligations are met. A company with high unlevered free cash flow could still face liquidity issues if it has significant debt service requirements that are not captured in this metric.
• Potential for Manipulation: Companies might strategically manage certain operational aspects (e.g., delaying capital expenditures or stretching accounts payable) to temporarily boost reported unlevered free cash flow, which might not be sustainable over the long term. Investors should scrutinize the drivers of changes in UFCF to distinguish between genuine operational improvements and temporary adjustments.
• Does Not Reflect Dividends or Buybacks: Unlevered free cash flow does not account for discretionary uses of cash such as dividend payments or share buybacks, which are important aspects of return on capital to shareholders.

Unlevered Free Cash Flow vs. Levered Free Cash Flow

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

Confusion often arises because both metrics measure "free cash flow," but they address different stakeholders. Unlevered free cash flow provides a picture of the overall cash-generating ability of the business itself, as if it were entirely financed by equity. Conversely, levered free cash flow, also known as free cash flow to equity (FCFE), represents the cash flow that is truly available to the company's equity holders after all operational and debt-servicing requirements have been met.

FAQs

What does "unlevered" mean in finance?

In finance, "unlevered" means before the effects of debt. When applied to metrics like cash flow, it implies that the calculation excludes expenses or cash movements related to a company's debt obligations, such as interest expense or principal repayments. This provides a view of a company's performance independent of its capital structure.

Why is unlevered free cash flow important for valuation?

Unlevered free cash flow (UFCF) is crucial for valuation because it offers an "apples-to-apples" comparison between companies. By removing the impact of different debt levels and financing decisions, analysts can assess the core operational performance and intrinsic value of a business. It is the preferred input for discounted cash flow (DCF) models when valuing the entire firm (enterprise value).

Is unlevered free cash flow the same as Free Cash Flow to Firm (FCFF)?

Yes, unlevered free cash flow (UFCF) is largely synonymous with Free Cash Flow to Firm (FCFF). Both terms refer to the cash flow generated by a company's operations that is available to all providers of capital—both debt and equity holders—before any financing expenses are considered.

How does depreciation impact unlevered free cash flow?

Depreciation is a non-cash expense that reduces a company's taxable income but does not involve an actual cash outflow. When calculating unlevered free cash flow, depreciation is added back to earnings (like EBIT) because the goal is to determine the actual cash generated by the business, not its accounting profit.

Can unlevered free cash flow be negative?

Yes, unlevered free cash flow can be negative. A negative unlevered free cash flow indicates that a company's core operations are not generating enough cash to cover its operating expenses and necessary investments (like capital expenditures and increases in working capital). This might occur in early-stage companies heavily investing for growth, or established companies facing operational challenges or significant reinvestment cycles.