Every business relies on cash flow. It is an important aspect of the growth of the business. The cash flow keeps the business operations running. It helps the business to effectively retain its earnings after paying off all its debts and operational cost. However, many businesses choose to fund their ventures in different ways. Thus, they regularly have varying amounts and timelines to deal with paying off their debt. The Unlevered Free Cash Flow is a useful comparative tool, especially for investors considering whether to invest money in one project over another, because it disregards these various quantities of debt related to how a company funds.
What is Unlevered Free Cash Flow?
Unlevered free cash flow is a company’s cash flow before liabilities are paid off. Therefore, it demonstrates how much cash the business has before paying its debts. In the UFCF, the amount of debt the business owes is not considered.
In highly leveraged deals, unlevered cash flow is utilized in DCF valuations or debt capacity analyses to determine the total cash a business generates for both debt and equity holders. The enterprise generates UFCF. Thus, its present value, like an EBITDA multiple, will provide you with the firm value.
Why is Unlevered Free Cash Flow Important?
Unlevered free cash flow is a crucial statistic for investors to comprehend a company’s health. It is crucial because it provides an estimate of how much debt the firm needs to operate and how much capital structure is needed. It helps investors understand how much debt the company is carrying. The main use of UFCF is to determine the net present values of a business in the case of the discounted cash flow model. The professional tax and accounting firm provides both unleveled and levered cash flow calculations for the business prospect.
Negative unleveraged cash flow indicates that a corporation is aggressively pursuing debt financing because it signifies that the business is either paying off existing debt or picking up new debt. Negative unlevered cash flow can also result from significant capital investments, which are often less profitable than utilizing debt to finance operations. A corporation may not be very successful if it needs to raise funds to support operations on a regular basis.
Even when a company’s unlevered cash flow is positive or negative, it does not always indicate whether a firm is a good investment or not.
Difference Between Unlevered and Levered Cash Flow
Here is a comparison between UFCF and LCF.
|Unlevered Free Cash Flow||Levered Cash Flow|
|UFCF = EBITDA – CAPEX – Working capital – Taxes.||LFCF = EBITDA – CAPEX – change in net working capital – mandatory debt payments.|
|Under UFCF, it is considered that all resources and possessions are of the founders.||Under LCF, it is considered that a company’s capital is borrowed and subject to debt obligations.|
|Various investment structures can be tested using UFCF analytics to see how they affect a company’s value.||The capital structure is taken into account by LFCF analysis when estimating the company’s cash flows|
|UFCF belongs to both the business’s equity owners and debtholders.||LFCF is the cash flow that belongs to the company’s equity shareholders|
Unlevered Free Cash Flow Calculation
By using EBIT
Here is the UFCF equation when you use EBIT. EBIT stands for Earnings before interest and taxes.
UFCF = EBIT – Taxes – Capital Expenditures – Changtaxe In Non-Cash Working Capital + Depreciation + Amortization
- Capital Expenditures are those that businesses have in material possessions.
- Non-cash working capital includes inventories, accounts receivable, and accounts payable.
UFCF from EBITDA
If you want to calculate the unlevered free cash flow from EBITDA, use the following formula.
UFCF = EBITDA – CAPEX – Working Capital – Taxes.
- EBITDA stands for Earnings before interest, taxes, depreciation & amortization.
- Working capital is the difference between assets and liabilities.
- CAPEX stands for capital expenditures which might include purchases of equipment and buildings
What are the Limitations of UFCF?
Each cash flow statistic needs to serve a specific purpose. Business leaders need to understand why they are using or relying on specific data when making critical choices.
However, there are some specific restrictions that apply to unlevered cash flow. The following are the main restrictions:
- Companies who have high debt profiles or are heavily leveraged yet want to show themselves favorably use UFCF.
- Businesses can exploit UFCF.
- Companies that use UFCF can postpone capital-intensive projects and lay off staff.
- The negative effect of UFCF has delayed payments to suppliers.
- The Firms can also use it to portray unrealized improvements by using UFCF.
Frequently Asked Questions
How to calculate Unlevered Cash Flow?
You can use the following unlevered free cash flow equation for calculation.
Unlevered free cash flow = Earnings before interest, tax, depreciation, and amortization – Capital expenditures – Working capital – Taxes
Who can benefit from Unlevered Free Cash Flow?
Unlevered free cash flow is useful in demonstrating enterprise value to
● Potential purchasers.
● Existing shareholders.
● Financial advisers.
What are the detrimental effects of UFCF?
The following are the negative aspects of UFCF calculation:
● It can fail to take capital structure into account.
● Companies may manipulate UFCF as per need.
● Businesses can exaggerate it to simply impress investors.
● It may have negative effects like layoffs.
Why is discounted cash flows (DCF) analysis preferable for unlevered free cash flow?
UFCF helps in giving a better picture of enterprise value (EV). It does not include debt and financing costs. Due to this, performing discounted cash flow analysis (DCF) helps in making proper investment comparisons.