From EBITDA to Levered Free Cash Flow: The Critical Connection for Investors

Why should you care about Levered Free Cash Flow? Because it’s the ultimate test of a company’s financial health and its ability to meet debt obligations. If you’re navigating through financial statements and you know EBITDA, you're halfway to understanding the real liquidity available for stakeholders. But transitioning from EBITDA to Levered Free Cash Flow (LFCF) is a crucial move, especially when assessing companies with significant leverage.

Levered Free Cash Flow goes beyond EBITDA by incorporating capital expenditures, taxes, and debt repayments. While EBITDA is an excellent proxy for operating profitability, it doesn't account for what’s truly "free" for shareholders. The "levered" aspect means it reflects the costs and obligations tied to a company’s debt, offering investors a glimpse into how much cash is available after fulfilling these responsibilities.

Let’s dive deep into how you get from EBITDA to LFCF and understand why this transition matters.

1. Start with EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is your starting point because it captures a company's core earnings from operations without the noise of non-operational costs like depreciation and taxes. It's a widely used measure in financial analysis because it offers a cleaner view of operational efficiency. However, it doesn't show the entire picture of cash flows, which is why we need to go further.

2. Subtract Taxes

The first major adjustment when moving from EBITDA to Levered Free Cash Flow is subtracting taxes. EBITDA doesn't account for tax expenses, but taxes are a real cash outflow that cannot be ignored. Taxes reduce the amount of cash available to pay down debt or return to shareholders.

Formula Adjustment:
EBITDA
- Taxes
= After-tax EBITDA

3. Subtract Capital Expenditures (CapEx)

Capital expenditures (CapEx) are essential for a company to maintain or expand its asset base, but they also represent a substantial cash outflow. Since CapEx isn't captured in EBITDA, it’s necessary to account for this expense when calculating LFCF. CapEx is usually listed on the cash flow statement, and it can vary significantly by industry and growth stage.

Companies with high CapEx requirements, like utilities or manufacturing firms, will have less free cash available after these expenditures. On the other hand, a tech company with minimal CapEx will likely have more free cash, even after paying off debt.

Formula Adjustment:
After-tax EBITDA
- CapEx
= Operating Cash Flow after CapEx

4. Adjust for Changes in Working Capital

Working capital is the difference between current assets and current liabilities. Changes in working capital affect cash flow because a company needs to fund its operations. An increase in working capital means more money is tied up in the day-to-day operations, reducing free cash flow. A decrease in working capital, on the other hand, frees up cash.

This step accounts for changes in accounts receivable, accounts payable, and inventory levels. If your working capital increases, it implies that the company is using more cash to maintain or expand operations. Conversely, if working capital decreases, it could signify that cash is being freed up.

Formula Adjustment:
Operating Cash Flow after CapEx
± Changes in Working Capital
= Operating Cash Flow after Working Capital Adjustments

5. Subtract Interest Payments

Since Levered Free Cash Flow reflects cash available after debt servicing, you need to subtract interest payments. Interest expenses represent cash outflows to lenders, and they are one of the most critical components when determining how much cash is truly available to equity holders. This is what distinguishes levered free cash flow from unlevered free cash flow.

For highly leveraged companies, interest payments can significantly reduce the amount of cash available for other uses, making this step pivotal in understanding a company’s true financial flexibility.

Formula Adjustment:
Operating Cash Flow after Working Capital Adjustments
- Interest Payments
= Pre-Debt Repayment Cash Flow

6. Subtract Principal Debt Repayments

After accounting for interest, principal debt repayments come next. Levered Free Cash Flow is the cash available after all financial obligations, including both interest and principal repayments. Principal payments are not part of the operating expenses but are crucial in determining how much cash a company has available for shareholders after meeting all its debt obligations.

Formula Adjustment:
Pre-Debt Repayment Cash Flow
- Principal Debt Repayments
= Levered Free Cash Flow

Levered Free Cash Flow Example

Imagine a company with the following figures:

• EBITDA: $500 million
• Taxes: $100 million
• CapEx: $150 million
• Changes in Working Capital: -$20 million (a decrease)
• Interest Payments: $50 million
• Principal Repayments: $80 million

Following the steps outlined above:

• EBITDA = $500 million
• After-tax EBITDA = $500M - $100M = $400M
• Operating Cash Flow after CapEx = $400M - $150M = $250M
• Operating Cash Flow after Working Capital Adjustments = $250M + $20M = $270M
• Pre-Debt Repayment Cash Flow = $270M - $50M = $220M
• Levered Free Cash Flow = $220M - $80M = $140 million

This company has $140 million in Levered Free Cash Flow, which is the cash available to shareholders after covering all necessary expenses and debt repayments. This is the figure investors look at when determining if the company can reinvest, pay dividends, or buy back shares.

Why Levered Free Cash Flow Matters

Levered Free Cash Flow is one of the most important financial metrics for investors, especially in companies with a significant amount of debt. It shows whether the company can continue to meet its debt obligations while still having cash left over for shareholders. In times of financial stress, a negative Levered Free Cash Flow could signal trouble ahead.

Unlike EBITDA, which only tells part of the story, Levered Free Cash Flow takes into account all major cash outflows. This makes it a more conservative and realistic metric when evaluating a company’s financial health. For companies with high levels of debt, Levered Free Cash Flow is particularly critical as it shows how much cash is left after paying off debt and covering operational needs.

Conclusion

Moving from EBITDA to Levered Free Cash Flow involves a series of adjustments that reveal how much cash a company really has left after paying for taxes, capital expenditures, and servicing its debt. By understanding this, investors gain insight into the company’s true financial flexibility. This can make all the difference when determining whether a company is capable of returning value to shareholders or if it's teetering on the edge of financial distress.

Levered Free Cash Flow is not just a number—it’s the key to understanding the cash that’s available to those who hold the company's debt and equity. If you're serious about evaluating a company's potential, LFCF should be at the top of your financial analysis toolkit.