Having a clear overview of a company’s true earning potential is extremely important. This is where unlevered free cash flow (UFCF) plays a crucial role. While “free” cash in businesses is typically utilized for reinvestments, debt repayments, acquisitions, and keeping reserves for future use, UFCF is the surplus cash generated from a company’s core operations, available for distribution to all stakeholders without considering debt obligations.
UFCF is an important metric for investors and stakeholders as it gives an unfiltered view of a company’s financial health, growth potential, and overall ability to generate returns. By focusing on UFCF, stakeholders can make more informed decisions that drive long-term value.
This blog enables you to understand in depth what unlevered free cash flow is, and its formula, and provides you with a comprehensive overview of its calculation with real-world examples.
Unlevered free cash flow represents the cash generated by a company’s operations after covering all expenses required to maintain its operations and assets, but before accounting for interest and taxes. UFCF indicates a company’s ability to generate cash for future investment, debt repayment, and interest rate reductions.
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The unlevered free cash flow equation is:
Unlevered free cash flow = EBIT × (1 − T) + Depreciation and amortization − Change in working capital − Capital expenditures
where,
EBIT refers to the earnings before interest and taxes.
EBIT × (1 − T) adjusts EBIT for taxes and represents after-tax income.
T is the corporate tax rate.
Depreciation and amortization are non-cash expenses, so they are added back into the formula.
Change in working capital is the difference in a company’s current assets and liabilities during a certain timeframe. It represents the net cash impact and, hence, is subtracted.
Capital expenditures represent the amount of money spent on acquiring or maintaining fixed assets. As it is a cash outflow, it is subtracted.
Unlevered free cash flow involves a step-by-step process. Here’s the breakdown of each step:
Calculate EBIT (Earnings Before Interest and Taxes)
Subtract operating expenses from revenue to obtain EBIT.
Formula: EBIT= Revenue – Operating Expenses
Adjust for taxes
Multiply EBIT by (1 – Tax Rate) to account for taxes. This step is necessary because taxes are deducted from EBIT to derive earnings after taxes.
Formula: EBIT * (1-Tax Rate)
Add depreciation and amortization
Add back depreciation and amortization to the result from step 2. Depreciation and amortization are non-cash expenses and are added back to reflect the cash available to the company.
Formula: Adjusted EBIT= After-tax EBIT + Depreciation + Amortization
Calculate the change in working capital
Determine the change in working capital by subtracting the previous period’s working capital from the current period’s working capital.
Formula: Current period working capital- Previous period working capital
Subtract capital expenditures (CapEx)
Subtract capital expenditures from the result obtained from step 3. Capital expenditures represent investments in long-term assets and are subtracted to reflect the cash outflows associated with these investments.
Summarize
Add or subtract the values obtained from steps 2, 3, 4, and 5 to calculate the unlevered free cash flow.
Formula: Adjusted EBIT- Change in Working Capital – CapEx
To calculate the unlevered free cash flow using the formula, let us consider company ABC with the following financial data:
Revenue: $800 million
Cost of goods sold (COGS): $400 million
Selling, general, and administrative expenses (SG&A): $150 million
Depreciation and amortization: $50 million
Interest expense: $30 million
Tax rate: 30%
Change in working capital: Increment of $20 million
Capital expenditures (CapEx): $100 million
Now,
1. Calculate EBIT (Earnings Before Interest and Taxes)
EBIT = Revenue – COGS – SG&A = $800M – $400M – %150M = $250M
2. Adjust for taxes
Tax = EBIT * Tax rate = $250M * 30% = $75M
EAT = EBIT – Tax = $250M – $75M = $175M
3. Add Depreciation and amortization:
EAT + Depreciation & Amortization = $175M + $50M = $225M
4. Calculate the change in working capital
Given: Increase of $20M
5. Subtract capital expenditure
Given: $100M
UFCF = $225M – $20M – $100M = $105M
So, the Unlevered Free Cash Flow (UFCF) for company ABC is $105 million.
Unlevered free cash flows are generally taken into consideration over levered free cash flow (LFCF) when building a DCF model because UFCF separates the operational performance of businesses from its financing decisions. By focusing on cash flows generated before debt and interest payments, UFCFs provide a clearer understanding of a company’s fundamental profitability and its ability to generate cash from core operations.
Unlevered free cash flow provides a consistent basis for valuation across companies and over time, facilitating meaningful comparisons within industries and enabling investors to make informed investment decisions. In DCF analysis, UFCF is foundational for estimating a company’s intrinsic value.
By discounting projected UFCFs to their present value using an appropriate discount rate, investors can assess the company’s worth based on its ability to generate cash flow and create shareholder value. This approach considers the interests of all capital providers, both debt and equity holders, and provides a comprehensive evaluation of the company’s potential returns.
Unlevered free cash flow and levered free cash flow are both measures used in financial analysis to assess a company’s financial performance and health. Here’s a comparison between UFCF and LFCF:
| Unlevered Free Cash Flow (UFCF) | Levered Free Cash Flow (LFCF) |
| UFCF represents the cash generated by a company’s operations before accounting for debt and interest payments. | LFCF represents the cash available to a company’s equity holders after accounting for debt and interest payments. |
| It is calculated by starting with Earnings Before Interest and Taxes (EBIT) and adjusting for taxes, depreciation, changes in working capital, and capital expenditures. | It is calculated by starting with unlevered free cash flow and subtracting interest expense and any required debt repayments. |
| UFCF is useful for evaluating a company’s core operational performance and its ability to generate cash independently of its capital structure. | LFCF can be used to assess a company’s ability to meet its financial obligations and generate returns for equity holders. |
Fluctuations in the market all over the world, evolving customer needs, and economic circumstances have brought a lot of challenges in predicting future cash flows from operations. HighRadius AI-driven Cash Forecasting Solution generates forecasts using AR (bank statements, customer invoices, sales orders) and AP (bank statements, open vendor invoices, purchase orders) with 95% accuracy on a weekly, monthly, and quarterly basis. Leveraging Advanced AI for AR and AP Forecast organizations can seamlessly perform what-if scenarios and compare actuals vs. forecasted cash. This helps companies better manage their operating cash flows and effectively plan for capital expenditures and changes in working capital, a critical component of UFCF.
HighRadius provides real-time visibility into global cash positions across various subsidiaries. Users can create, track, and manage debt and investments, such as bank loans, term loans, letters of credit, etc., in a single place, including intercompany loans or investments. This helps companies maintain control over their cash resources, ensuring they have a clear understanding of their available cash for operational needs, independent of financing activities.
Managing receivables, payables, and inventory is crucial but challenging. Delays in receivables, excessive inventory, or poor payment terms with suppliers can significantly impact UFCF. By integrating receivables, payables, and inventory management, HighRadius helps optimize working capital. Efficient management of working capital components ensures that the changes in working capital are minimized, positively impacting UFCF.
Unlevered free cash flow (UFCF) is calculated as:
Unlevered free cash flow = EBIT × (1 − T) + Depreciation and amortization − Change in working capital − Capital expenditures
This represents the cash flow available to all investors after accounting for CapEx, tax, and depreciation, excluding debt financing.
Yes, unlevered free cash flow includes taxes. It is calculated after accounting for taxes on operating income. Taxes are a necessary expense that affects the company’s operating cash flow, so they must be included to accurately represent the cash available from operations.
Depreciation needs to be added back while calculating unlevered free cash flow because it’s a non-cash expense. It reduces taxable income, lowering taxes paid, but doesn’t involve actual cash outflow. Thus,
UFCF = EBIT × (1 – Tax Rate) + Depreciation + Amortization – CapEx – Change in working capital.
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