Unlevered Free Cash Flow

When evaluating a company’s financial health, one of the key metrics analysts often focus on is unlevered free cash flow (UFCF). Unlike standard cash flow measures, UFCF takes into account the company’s ability to generate cash before considering the effects of debt financing. This makes it an essential metric for understanding how well a company can sustain its operations and invest in growth without the influence of its capital structure.

In this article, we will break down what unlevered free cash flow is, how it is calculated, and why it is a critical component for financial analysis and valuation.

What is Unlevered Free Cash Flow?

Unlevered free cash flow (UFCF) represents the amount of cash a company generates from its operations after accounting for capital expenditures, but before paying any interest expenses on debt. It is the cash flow that would be available to all investors—both debt and equity holders—if the company had no debt. In essence, unlevered free cash flow provides insight into a company’s operating performance without the influence of its capital structure.

UFCF is often used in valuation models, particularly when performing a Discounted Cash Flow (DCF) analysis. It provides a clearer picture of a company’s ability to generate cash from operations, irrespective of the debt obligations it has.

Unlevered Free Cash Flow Formula

The basic formula to calculate unlevered free cash flow is:

$$\text{UFCF}=\text{EBIT}\times (1-\text{Tax Rate})+\text{Depreciation and Amortization}-\text{Change in Working Capital}-\text{Capital Expenditures}$$

Where:

• EBIT (Earnings Before Interest and Taxes): This is the company’s operating income, which is used to measure profitability before the impact of debt.
• Tax Rate: The applicable tax rate for the company.
• Depreciation and Amortization: Non-cash charges that reduce the value of tangible and intangible assets.
• Change in Working Capital: Adjustments for changes in current assets and liabilities, which represent the company’s short-term financial health.
• Capital Expenditures (CapEx): Cash spent on acquiring, maintaining, or improving fixed assets such as property, plant, and equipment.

Importance of Unlevered Free Cash Flow

1. Provides a Clear Picture of Operational Performance: Since UFCF excludes interest expenses, it gives a clearer view of how efficiently a company generates cash from its core business operations. It allows investors and analysts to compare companies regardless of their capital structure (i.e., whether they are highly leveraged or not).

2. Used in Valuation Models: UFCF is commonly used in Discounted Cash Flow (DCF) analysis to estimate the value of a company. By projecting UFCF over a period and discounting it back to the present value, investors can estimate the intrinsic value of a company. This helps in assessing whether the company’s stock is undervalued or overvalued.

3. Reflects Cash Flow Available to All Stakeholders: Since unlevered free cash flow excludes debt payments, it represents the cash available to all stakeholders, both equity and debt investors. This makes it an important measure for assessing the overall financial strength and sustainability of a company.

4. Helps in Assessing Debt Capacity: Although UFCF excludes debt-related payments, it is still useful for understanding how much cash a company generates and can potentially use to service its debt obligations. Investors and creditors alike use UFCF to evaluate whether a company has enough cash flow to handle future debt repayments.

5. Key for Growth and Investment Analysis: UFCF highlights how much cash a company has available to reinvest in business growth, such as expanding operations, acquiring new assets, or funding research and development projects. A higher UFCF means the company can fund more investments and still generate a solid return.

Unlevered Free Cash Flow vs. Levered Free Cash Flow

While unlevered free cash flow represents cash flow before considering any debt payments, levered free cash flow (LFCF) takes debt payments into account. LFCF shows the amount of cash available to equity holders after all expenses, including interest payments on debt, have been paid.

• Unlevered Free Cash Flow: Focuses on the company’s ability to generate cash from operations before accounting for debt.
• Levered Free Cash Flow: Shows the cash left for shareholders after the company has made interest payments on its debt.

LFCF is useful for assessing a company’s ability to service its debt and reward equity holders, while UFCF is helpful for understanding operational cash flow and for valuing companies without considering how much debt they carry.

Why Unlevered Free Cash Flow Matters for Investors

Investors use unlevered free cash flow to gauge how well a company is performing on a fundamental level. Here’s why it matters:

1. Consistency and Stability: A company with consistent and growing UFCF is considered financially stable. Investors can rely on its ability to generate cash from its core business without relying on debt or external financing.

2. Valuation Tool: UFCF is often the preferred metric for valuing companies, especially in cases where comparing firms with different capital structures. By excluding debt, UFCF provides a more accurate view of the company’s fundamental value.

3. Capital Efficiency: High UFCF indicates that a company is generating more cash with fewer resources. Companies with high UFCF relative to their capital expenditures and working capital requirements tend to be more efficient and profitable in the long term.