Unlevered free cash flow is the amount of a company's cash flow available before considering its financial obligations. These are the operating cash flow the company is free to use however it likes.
Companies report unlevered free cash flow because it is a good indication of how the company is using its assets to generate cash rather than just looking at the cash flow statement. In fact, companies that have a large amount of debt prefer to show UFCF. Also, investors and lenders like to know the gap between leverage and UFCF based on this difference they can tell whether the company has too much debt to handle or is operating using a healthy amount of debt financing.
If the company's UFCF is high but its levered cash flow is low, it may indicate the company is using a significant amount of cash on debt service. If the UFCF is low, but there is only a small gap between a UFCF and leverage cash flow it could be an indication the company is barely getting by on the cash it generates and may have financial troubles if the revenue drops.
There are several types of cash flow or cash flow like metrics. That includes EBIT cash flow or cash flow from operations, free cash flow, free cash flow to equity and free cash flow to the firm which is called unlevered free cash flow.
Free cash flow to the firm which is the unlevered free cash flow requires multi-step calculation and is used in DCF analysis to arrive at the enterprise value. It is a hypothetical figure to estimate the firm value if it has no debt. The formula of free cash flow to the firm is:
FCFF = EBIT * (1 – Tax) + Depreciation & Amortization – Increase in Non-Cash Working – Capital expenditures
Because it doesn't take into account the usage of debt or equity, unlevered free cash flow enables a more accurate comparison of businesses based on their discounted cash flows. Additionally, because it employs a lower discount rate, which is a combination of the company's debt interest rate and equity return rate, it can generate a higher present value of discounted cash flows. A company's weighted average capital cost is what this (WACC) means.
WACC (Weighted average cost of capital, which calculates enterprise value) is used as discount rate for UFCF, whereas cost of equity (which calculates equity value only) is used as discount rate for LFCF.
Theoretically, the owners or management of the business can give it any capital structure they wish. In practice, however, corporations may have flexibility restrictions that make this statement rather theoretical.
The influence of interest can skew the levered cash flow of two businesses since some businesses have large interest expenses while others have little to no interest expenses. It is considerably simpler to compare by eliminating the interest expense and recalculating taxes.
The gross free cash flow produced by a corporation is known as unlevered free cash flow. If cash flows are leveraged, they are after interest payments, which is another name for debt. Unlevered free cash flow is the free cash flow that can be used to pay both equity and debt holders as well as other stakeholders in a company.
UFCF is used by businesses that have huge debt loads or high levels of leverage but nevertheless wish to show themselves favorably. Companies that use UFCF may postpone capital-intensive projects, delay payments to suppliers, and fire personnel. Companies have the ability to control unlevered free cash flow. Using UFCF, businesses can present advances that are not real.
Viewing unlevered free cash flow in a bubble ignores a company’s capital structure because it is calculated prior to interest payments. The levered free cash flow of a company may really be negative after accounting for interest payments, which could portend adverse effects in the future. Analysts should look for trends in cash flow statements, operating cash flow, net income, free cash flow margin, net income, unlevered and levered free cash flow over time rather than placing undue emphasis on any particular year.
Unlevered free cash flow paints a better picture of the company’s financial health than levered free cash flow, which is more likely to be reported by heavily indebted companies. Debt commitments must be taken into account by investors since highly leveraged businesses are more likely to fail.
Levered free cash flow differs from unlevered free cash flow by including borrowing costs. Levered cash flow (LFCF) is the amount of cash left over after a company has paid all of its debts, including interest, loans, and other financing costs. Unlevered free cash flow is the amount of money available to the company prior to meeting its debt obligations. Levered free cash flow will be used to pay debts.
Another crucial indicator is the variation in cash flow between leveraged and unleveraged situations. The difference reveals how much debt the company is carrying and if it is healthy or overextended in terms of debt. If a company’s expenses outweigh its revenue, it may have negative levered cash flow. Even if this is not a good condition, investors shouldn't be alarmed as long as it lasts a short while.
