How to Get Unlevered Free Cash Flow

Unlevered free cash flow (UFCF) is a critical metric for evaluating a company's financial health and its ability to generate cash from operations without the impact of capital structure or debt. Understanding UFCF helps investors and financial analysts assess a company's potential for growth, its ability to handle economic downturns, and its value for potential investments or acquisitions. In this article, we will explore the concept of UFCF, its calculation, and its significance in financial analysis.

What is Unlevered Free Cash Flow?
Unlevered free cash flow represents the cash a company generates from its core operations before accounting for interest payments, taxes, and changes in working capital. Unlike levered free cash flow, which considers the impact of debt and interest expenses, UFCF provides a clearer picture of a company's operational efficiency and cash generation capabilities.

Why is UFCF Important?

1. Valuation Analysis: UFCF is crucial for discounted cash flow (DCF) analysis, which is a common method for valuing companies. By focusing on the cash flows generated from operations without the impact of financing decisions, analysts can better estimate a company's intrinsic value.
2. Investment Decisions: Investors use UFCF to assess the financial health of a company and its potential for future growth. A strong UFCF indicates that a company is capable of funding its operations, investing in growth opportunities, and returning value to shareholders.
3. Performance Comparison: UFCF allows for more accurate comparisons between companies within the same industry. Since UFCF is unaffected by capital structure, it provides a consistent basis for evaluating operational performance.

How to Calculate Unlevered Free Cash Flow
The calculation of UFCF involves several steps and components. Here's a step-by-step guide:

1. Start with Earnings Before Interest and Taxes (EBIT): EBIT represents a company's profitability from its core operations before accounting for interest and taxes.
2. Subtract Taxes: Adjust EBIT for taxes to reflect the actual cash generated. The formula is: $\text{EBIT}-\text{Taxes}=\text{EBIT after Taxes}$EBIT−Taxes=EBIT after Taxes
3. Add Back Non-Cash Expenses: Non-cash expenses such as depreciation and amortization should be added back, as they do not represent actual cash outflows. $\text{EBIT after Taxes}+\text{Depreciation}+\text{Amortization}=\text{Adjusted EBIT}$EBIT after Taxes+Depreciation+Amortization=Adjusted EBIT
4. Subtract Changes in Working Capital: Working capital changes, including accounts receivable, inventory, and accounts payable, affect cash flow. Adjust for these changes to reflect cash used or generated by working capital. $\text{Adjusted EBIT}-\text{Changes in Working Capital}=\text{Cash Flow from Operations}$Adjusted EBIT−Changes in Working Capital=Cash Flow from Operations
5. Subtract Capital Expenditures: Capital expenditures (CapEx) are investments in long-term assets that are necessary for maintaining and expanding operations. Subtract these expenses to calculate UFCF. $\text{Cash Flow from Operations}-\text{CapEx}=\text{Unlevered Free Cash Flow}$Cash Flow from Operations−CapEx=Unlevered Free Cash Flow

Example Calculation
Let's consider a hypothetical company with the following financial data:

• EBIT: $500,000
• Taxes: $100,000
• Depreciation: $50,000
• Amortization: $20,000
• Increase in Accounts Receivable: $30,000
• Decrease in Inventory: $10,000
• Increase in Accounts Payable: $20,000
• Capital Expenditures: $70,000

The UFCF calculation would be:

1. EBIT after Taxes: $\$500,000-\$100,000=\$400,000$$500,000−$100,000=$400,000
2. Adjusted EBIT: $\$400,000+\$50,000+\$20,000=\$470,000$$400,000+$50,000+$20,000=$470,000
3. Changes in Working Capital: $\$30,000-\$10,000+\$20,000=\$40,000$$30,000−$10,000+$20,000=$40,000
4. Cash Flow from Operations: $\$470,000-\$40,000=\$430,000$$470,000−$40,000=$430,000
5. Unlevered Free Cash Flow: $\$430,000-\$70,000=\$360,000$$430,000−$70,000=$360,000

Applications and Limitations of UFCF
While UFCF is a valuable tool for assessing a company's financial health, it has its limitations. UFCF does not account for financing decisions, which can be significant for companies with substantial debt. Additionally, UFCF does not consider changes in capital structure or interest rates, which can impact a company's overall financial stability.

Conclusion
Understanding and calculating unlevered free cash flow is essential for making informed investment decisions and evaluating a company's financial performance. By focusing on cash generated from core operations, UFCF provides a clearer view of a company's operational efficiency and its potential for future growth. However, it's important to consider UFCF alongside other financial metrics and factors to gain a comprehensive understanding of a company's financial health.