How to Calculate Levered Free Cash Flow from Unlevered Free Cash Flow

Introduction
Unlocking the secret to understanding a company's true financial health involves diving deep into the calculations of cash flow. If you've ever wondered how to transition from unlevered free cash flow (UFCF) to levered free cash flow (LFCF), you’re in the right place. The process might seem complex, but once broken down, it becomes quite manageable. We’ll unravel the nuances of these financial metrics and guide you through the transformation.

What is Unlevered Free Cash Flow?
Unlevered Free Cash Flow represents the cash a business generates before any financial obligations like interest payments are considered. It provides insight into a company's ability to generate cash from its operations without the impact of debt. To calculate UFCF, you typically start with operating income, add back non-cash expenses, adjust for changes in working capital, and subtract capital expenditures.

What is Levered Free Cash Flow?
On the other hand, Levered Free Cash Flow measures the cash available to equity holders after all financial obligations, including interest and debt repayments, have been met. This is a more refined metric that reflects the true cash position available to shareholders. Calculating LFCF involves starting with UFCF and then adjusting for interest payments and net debt repayments.

Step-by-Step Calculation
Here’s a clear, step-by-step guide to converting UFCF to LFCF:

1. Calculate Unlevered Free Cash Flow

   • Start with EBIT (Earnings Before Interest and Taxes): This figure represents the operating profit before interest and tax expenses.
   • Adjust for Taxes: Subtract taxes to reflect the cash flow after tax expenses. Taxes are typically calculated using the formula: EBIT * Tax Rate.
   • Add Back Depreciation and Amortization: These non-cash expenses are added back to EBIT.
   • Adjust for Changes in Working Capital: Increase in working capital reduces UFCF, and a decrease increases it.
   • Subtract Capital Expenditures: Deduct capital expenditures to account for investments in property, plant, and equipment.

   Formula:

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

2. Adjust for Interest Payments

   • Identify Interest Expenses: These are the costs of debt that need to be paid out of cash flow.
   • Subtract Interest Payments from UFCF: This will adjust the cash flow to reflect what’s available to equity holders after servicing debt.

3. Adjust for Net Debt Repayments

   • Identify Debt Repayments: Include both principal and any scheduled repayments.
   • Subtract Net Debt Repayments: Deduct these repayments from the cash flow to get the amount left for equity holders.

   Formula:

   $\text{LFCF}=\text{UFCF}-\text{Interest Payments}-\text{Net Debt Repayments}$LFCF=UFCF−Interest Payments−Net Debt Repayments

Example Calculation
Let’s put this into practice with a simple example:

• EBIT: $1,000,000
• Tax Rate: 30%
• Depreciation: $50,000
• Amortization: $30,000
• Change in Working Capital: $20,000
• Capital Expenditures: $100,000
• Interest Payments: $60,000
• Net Debt Repayments: $40,000

First, calculate UFCF:

$\text{UFCF}=\$1,000,000\times (1-0.30)+\$50,000+\$30,000-\$20,000-\$100,000$UFCF=$1,000,000×(1−0.30)+$50,000+$30,000−$20,000−$100,000$\text{UFCF}=\$700,000+\$50,000+\$30,000-\$20,000-\$100,000$UFCF=$700,000+$50,000+$30,000−$20,000−$100,000$\text{UFCF}=\$660,000$UFCF=$660,000

Then, calculate LFCF:

$\text{LFCF}=\$660,000-\$60,000-\$40,000$LFCF=$660,000−$60,000−$40,000$\text{LFCF}=\$560,000$LFCF=$560,000

Understanding the Difference
The difference between UFCF and LFCF primarily hinges on the company’s debt obligations. UFCF provides a snapshot of cash generation capacity without the influence of financing, whereas LFCF offers a more conservative view by factoring in the costs of servicing debt.

Why It Matters
Understanding the transition from UFCF to LFCF is crucial for investors and analysts as it reflects the cash flow available for shareholder returns. It’s a critical measure for evaluating the sustainability of dividends, share buybacks, or other equity returns.

Conclusion
Calculating Levered Free Cash Flow from Unlevered Free Cash Flow might appear intricate, but breaking it down into clear steps simplifies the process. By adjusting for interest payments and net debt repayments, you gain a more accurate picture of the cash available to shareholders, which is indispensable for making informed financial decisions.