Why use unlevered cash flow

Although each business and valuation situation is unique, an example of this calculation is below. For this situation, imagine a construction and real estate development company in the first year of business. The information for completing this equation may change quarterly and annually. In the example above, the company likely required a significant number of initial investments to get the business up and running. A simple cash flow statement may not be enough for these investors. In this instance, UFCF can be used to illustrate a more detailed future outlook for a specific company.

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You may disable these by changing your browser settings, but this may affect how the website functions. To learn more about how we use your data, please read our Privacy Statement. They are similar to the levered cash flows or free cash flow to equity, except they value its operations.

We will get to the formula calculations in a moment, but the unlevered cash flows focus on the operations of the business and the capital investments needed to grow those revenues and operations. The main focus of the unlevered cash flows is the operating earnings of the company, represented by the operating earnings or margins.

The levered cash flows measure the net earnings of the company. We call it an unlevered free cash flow because it is measured before any debt payments, i. A downside to this use is the tax benefits a company receives for interest payments, as there is no capturing those benefits in calculating unlevered free cash flows. Part of this is by design because when we calculate the cost of capital, we use the after-tax cost of debt, and including that in unlevered cash flow calculations would be double counting.

Before continuing, if you are not familiar with the cost of capital or WACC weighted average cost of capital , please follow the link below to familiarize yourself with that before proceeding. The cost of capital is a critical piece of calculating unlevered free cash flow values, and you will be lost unless you understand that idea.

Okay, now that we understand what unlevered cash flows are and calculate our cost of capital. The main differences between unlevered firm and levered equity cash flows are the treatment of debt.

There are many items that investors need to address when building cash flows. They are:. We use many of the same inputs to calculate free cash flows, but dealing with the above items determines which type of cash flow we wish to use. There is a financial metric in wide use in finance, EBITDA earnings before interest, taxes, depreciation, and amortization which mirrors levered cash flows. A few differences exist between EBITDA and levered free cash flows, and those are the potential tax liability from earnings, plus accounting for capital investments and working capital requirements.

The main measure of levered free cash flows comes from EBIT earnings before interest and taxes. To arrive at operating earnings, we remove all of the operating costs from revenues. To arrive at levered cash flows, we also need to account for the impact on taxes, which we tax on the operating earnings of the business. The EBIT or operating income comes directly from the line item on the income statement. But before we do that, we need to account for capital expenditures, or invested capital, which is a combination of debt and equity, or depreciation, capital expenditures, and changes in working capital.

That is why we use unlevered cash flows in a DCF model to value companies. The best way to illustrate how this works is to use its financials to put it all together. All numbers listed will be in millions unless otherwise stated:. Now, we can plug all these into the formula, but first, we need to calculate the tax rate.

We divide the taxes by the operating income, which equals:. That is fairly straightforward once we know where to get the inputs. The inputs are standard line items, but one of them that is a little more off the usual radar is the change in non-cash working capital. The usual standard fare is to use either the difference between current assets and current liabilities to determine the change in working capital. Or, to use the change in working capital, you can calculate from the cash flow statement.

However, per both Aswath Damodaran and Michael Mauboussin, a more accurate method is to use the non-cash working capital. The reason for this is it gives us a better insight into the working capital the company is using to drive growth. If this is confusing, please refer to the following link to better explain:.

We need to discuss the growth rate for revenues, which moves down the line to the unlevered cash flows. So, in some ways, levered cash flows are seen as the more reliable method of financial modeling. It only measures cash working capital and takes out non-cash expenses, so you gain a much better look at how much cash you have on hand. If you have a healthy amount of debt and net working capital, then you may want to consider using levered free cash flows for your DCF projections.

You should be able to find all of the required information on your balance sheet. The equation for levered free cash flows is:. LFCF allows you to measure your operating income. Like levered cash flows, you can find unlevered cash flows on the balance sheet. Enterprise value is considered more in-depth than equity market capitalization, which measures the total value of a company based on relative size.

Enterprise value considers both short-term and long-term debts and can show what a company is actually worth. Unlevered free cash flow indicates the number of funds available before accounting for expenditures like debt and interest expenses. Because it affects the amount of cash a business has on-hand to pay its bills, unlevered free cash flow has a direct impact on internal accounting decisions.

In fact, companies often utilize UFCF when setting up their annual budgets and determining whether or not various department heads are utilizing their funding effectively. Additionally, a company may track UFCF to paint the business in a better light to shareholders and potential buyers. As a result, the company may appear more successful and solvent than it truly is, demonstrating a higher amount of working capital. As a result, investors will want to know the unlevered free cash flow value, as this reveals how much capital will be available down the line after making interest payments and paying down the net debt balance.

You can find all of the necessary information on your income statement. Next, identify your capital expenditures CAPEX , or the money used to fund daily business activities. You can find this information on the cash flow statement. This leaves you with an equation that looks like this:. As you can see, the equation for unlevered free cash flow is not nearly as extensive as the one for levered free cash flow. While a smaller gap between LCF and UFCF indicates that fewer funds are available for investment and expansion, a more significant difference suggests a robust and healthy business.

Additionally, the difference between unlevered and levered free cash flow can reveal whether the business has taken on too much debt.