Levered vs. Unlevered Free Cash Flow: What’s the Difference?

What really separates companies with high profitability from those that struggle to meet their financial obligations? The answer often lies in how they manage their cash flows. Investors, analysts, and business leaders focus intensely on two key metrics: levered free cash flow (LFCF) and unlevered free cash flow (UFCF). While they sound similar, they reveal very different aspects of a company's financial health, risk profile, and operational flexibility. This article will take a deep dive into understanding the difference between these two financial metrics, why they matter, and how they can shape investment decisions.

Understanding Free Cash Flow (FCF)

At its core, free cash flow (FCF) represents the cash a company generates after accounting for its capital expenditures (CapEx). This cash is available to investors, either through dividends, share buybacks, or reinvestment into the business. Unlike earnings or net income, FCF gives a much clearer view of how much real, liquid capital is available at the end of the day.

However, FCF comes in two varieties: levered and unlevered. This distinction revolves around how a company's debt and interest payments impact its financial picture.

Levered Free Cash Flow (LFCF)

Levered Free Cash Flow refers to the cash a company has left over after fulfilling its debt obligations, including paying interest and principal. In simpler terms, LFCF reflects the cash flow available to equity holders after the company meets all of its financial obligations to creditors.

The formula for LFCF is as follows:

$\text{LFCF}=\text{Net Income}+\text{Depreciation and Amortization}-\text{Changes in Working Capital}-\text{Capital Expenditures}-\text{Debt Payments}$LFCF=Net Income+Depreciation and Amortization−Changes in Working Capital−Capital Expenditures−Debt Payments

Key Points about LFCF:

1. Focuses on Equity Holders: Since debt payments are subtracted, LFCF reflects what remains for shareholders after lenders are paid.

2. Risk Reflection: Companies with high levels of debt will often have lower LFCF, as large portions of their income go toward servicing debt. This can indicate higher financial risk, as the company may not have sufficient free cash flow to weather downturns or make new investments.

3. Less Flexibility: Levered companies, or those with significant debt, typically have less operational flexibility. Since LFCF is calculated after accounting for debt payments, companies with high debt burdens might find themselves constrained in terms of reinvestment or pursuing new opportunities.

Unlevered Free Cash Flow (UFCF)

Unlevered Free Cash Flow, on the other hand, represents the cash flow before any debt payments are made. It reflects the cash available to both equity holders and debt holders. As a result, UFCF is often used to evaluate a company's overall financial performance without considering the effects of its capital structure.

The formula for UFCF is:

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

Key Points about UFCF:

1. Neutral on Debt: UFCF provides a clearer picture of the company’s operational efficiency, as it ignores how the business is financed (debt or equity).

2. Ideal for Company Valuation: Because UFCF does not account for interest payments, it’s often used in Discounted Cash Flow (DCF) models. This is because UFCF represents the company’s ability to generate cash, regardless of its capital structure.

3. Shows Potential: UFCF is a key indicator of a company’s future growth potential. Since it does not subtract debt payments, it gives a clearer idea of how much cash flow is available for strategic reinvestment or to improve operational capacity.

Comparative Analysis: Levered vs. Unlevered Free Cash Flow

Metric	Levered Free Cash Flow (LFCF)	Unlevered Free Cash Flow (UFCF)
Debt Inclusion	After debt payments	Before debt payments
Focus	Cash available to equity holders	Cash available to both debt and equity holders
Financial Health	Indicates the company's ability to meet debt obligations	Shows overall operational efficiency
Valuation Use	Limited in use for DCF	Frequently used in DCF
Operational Flexibility	Often lower, especially in highly leveraged firms	Reflects more potential operational flexibility

When to Use Levered vs. Unlevered Free Cash Flow

1. Evaluating Debt-heavy Firms: If you are assessing a company with significant debt, LFCF is the go-to metric. It shows how well the company is managing its debt load and if it has enough cash left over to return value to shareholders. However, if the debt load is too high, LFCF might be lower, indicating that the company is at greater financial risk.

2. Building Discounted Cash Flow Models: For most valuation purposes, especially using DCF, UFCF is the preferred metric. It eliminates the distortions that debt can introduce, giving a purer view of the company’s cash-generating potential.

3. Assessing Dividend or Buyback Potential: LFCF is especially relevant for equity investors focused on dividend income or stock buybacks. Since it reflects the cash available to equity holders, it can indicate whether a company will likely maintain or increase its dividend payouts.

4. Strategic Planning for Business Growth: UFCF is key when assessing a company’s ability to reinvest in its business, expand its operations, or acquire new assets. Since it ignores debt payments, UFCF gives management a clearer view of how much operational cash flow is available to pursue growth opportunities.

Impact of Leverage on Business Decisions

Leverage (the use of borrowed capital) can be a powerful tool to boost returns, but it also introduces risk. Companies with high levels of leverage might see their LFCF squeezed, even if their UFCF is strong. This tension can create operational stress, especially during economic downturns or periods of rising interest rates.

Here are a few scenarios where understanding the difference between LFCF and UFCF becomes crucial:

• Scenario 1: Rising Interest Rates If interest rates rise, companies with high leverage will see their LFCF decrease, as they need to pay more to service their debt. However, their UFCF might remain stable, masking the potential risk to equity holders.

• Scenario 2: Business Expansion If a company is planning to expand, UFCF will give management a clear picture of how much capital is available for investment without considering debt. However, LFCF will indicate if the company can sustain such expansion after paying off its obligations.

• Scenario 3: Market Downturns In a downturn, highly levered companies might struggle to maintain positive LFCF, even if their operations (as reflected by UFCF) are strong. This makes it more difficult for these companies to raise new capital, as investors will worry about their ability to meet debt payments.

How to Calculate Levered and Unlevered Free Cash Flow

Let’s break down a practical example:

Metric	Amount ($ in millions)
Revenue	500
Operating Expenses	300
EBIT	200
Tax Rate	25%
Depreciation/Amortization	50
Capital Expenditures	40
Interest Expense	20
Debt Repayment	30

Step 1: Calculate UFCF

$\text{UFCF}=(200\times (1-0.25\left)\right)+50-40=160\text{million}$UFCF=(200×(1−0.25))+50−40=160million

Step 2: Calculate LFCF

$\text{LFCF}=160-20-30=110\text{million}$LFCF=160−20−30=110million

Conclusion

Understanding the distinction between levered and unlevered free cash flow is essential for both investors and corporate decision-makers. While UFCF gives a broad, debt-neutral view of a company's ability to generate cash, LFCF drills down into the risks and obligations faced by equity holders. Whether you're valuing a business for acquisition, determining a company's dividend potential, or assessing its financial health, knowing how to use and interpret these cash flow metrics can provide a clearer picture of what the future holds.