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9 Min. Read

Levered vs. Unlevered Free Cash Flow: Top 7 Differences

Levered vs. Unlevered Free Cash Flow: Top 7 Differences

As a business owner, entrepreneur, or financial manager, you know that most business operations depend on cash flow. The amount of cash you manage on a daily, quarterly, and annual basis has implications for the way you grow and sustain a company.

From an accounting perspective, did you know that there are actually several types of free cash flow? If you're not an accounting expert, don't worry. In this post, we've got you covered with an in-depth explanation of levered vs unlevered free cash flow to help you better understand your company's financial health and enterprise value.

Here’s What We’ll Cover:

What is Free Cash Flow?

Top 7 Differences in Levered vs Unlevered Free Cash Flow

What You Can Learn by Comparing Levered vs Unlevered

Are There Any Similarities in Cash Flow?

More Accounting Resources for Businesses

What is Free Cash Flow?

Free cash flow is the amount of money that a business has after settling debt payments, operating expenses, payroll expenses, and taxes. Free cash flow appears on a cash flow statement and represents the amount of money that remains after accounting for outflows.

In most general applications, accounting professionals recognize two types of free cash flow: unlevered free cash flow (UFCF) and levered free cash flow (LFCF).

Keep reading to discover the definitions, formulas, and comparisons for each cash flow type.

What is Unlevered Free Cash Flow?

The term 'unlevered' in free cash flow corresponds to the amount of money that is available before meeting financial obligations. Unlevered free cash flow is a theoretical dollar amount that exists on the cash flow statement prior to paying debts, expenses, interest payments, and taxes. 

Unlevered free cash flow is usually only visible to financial managers and investors, rather than to the average consumer. It showcases enterprise value to debtholders with a stake in the company's financial wellbeing. 

This metric may also be called free cash flow to firm (FCFF). Regardless of how it is named, the most important thing to remember is that it's indicative of gross (rather than net) free cash flow.

Unlevered Free Cash Flow Formula

In accounting, the following formula is useful for calculating unlevered free cash flow (UFCF).

UFCF = EBITDA - CAPEX - Working Capital - Taxes

In this equation–

  • EBITDA represents “Earnings Before Interest, Taxes, Depreciation, and Amortization"
  • CAPEX represents building and equipment investments that are essential for business growth
  • Working capital is the difference between assets and liabilities
  • Taxes can include any local, state, or federal business tax

What is Levered Free Cash Flow?

By definition, levered free cash flow (LFCF) is the amount of cash that an organization or business holds onto after it has satisfied recurring financial obligations and payments. Both short and long-term payments are included in this calculation.

Levered free cash flow is the money that still exists after:

  • Interest expenses
  • Regular operational expenses
  • Local, state, and federal taxes
  • Capital expenditures (CAPEX)

Levered free cash flow doesn't imply that a company has bad or harmful debt. Rather, it shows what money is available after expenses in order to build equity or make investments.

Levered Free Cash Flow Formula

In accounting, the following formula is useful for calculating levered free cash flow (LFCF).

LFCF = EBITDA - Change in Net Working Capital - Capital Expenditures (CAPEX) - Debt (D)

In this equation–

  • EBITDA represents “Earnings Before Interest, Taxes, Depreciation, and Amortization” 
  • ΔNWC represents a change in net working capital
  • CAPEX represents investments in building, land, and equipment
  • D represents any debt payments made from free cash flow reserves

Top 7 Differences in Levered vs Unlevered Free Cash Flow

The primary differences in these cash flows hinge on the addition of business expenses within the equation. This is the primary block upon which the other differences will build.

1. Inclusion of Expenses

With the above definitions in mind, unlevered free cash flow does not include expenses, while levered free cash flow factors them in. If you remember one rule of thumb regarding cash flows, it should be this.

Keep in mind that for business accounting purposes, the broad term for expenses can include more than operating expenses. Expenses can also include any interest expense, debt payment, taxes, or capital expenditures.

Think about these types of cash flow in terms of a "before and after" state. For this scenario, unlevered free cash flow is the before state, and levered free cash flow is the after state. The action in between is the settlement or payment of recurring expenses.

2. Financial Obligations

Depending on which type of free cash flow metric a company uses, there are different financial obligations to satisfy before stating the final amount.

When using a levered free cash flow formula, the company is obligated to settle on expenses and amounts owed to debt holders prior to calculating a final total. 

On the other hand, a company that uses the levered free cash flow formula doesn't have the same obligation of paying those amounts (for the purpose of reporting UFCF only). This isn't to say that the company is not responsible for its debts, investments, or taxes, but simply that it doesn't need to settle them prior to reporting unlevered free cash flow.

3. Users and Stakeholders

There tends to be overlap in the users, stakeholders, and interested parties who rely on both unlevered and levered free cash flow. The reason for selecting one or the other often depends on the desired intention and on the level of transparency required.

Unlevered free cash flow tends to be used by investment bankers and potential buyers. These individuals want to view the big picture in order to make decisions. UFCF may also be used by department heads to establish annual budgets and to ensure that managers are using all available funds in effective ways.

Levered free cash flow can also be used by bankers and buyers, but it has other internal uses. Business owners may rely on this metric to make decisions about future capital investments and improvements. Similarly, a board of executives may take a careful look at the levered free cash flow amount to prove equity or value to debt holders.

4. Cash Flow Formulas

Formulas are important for making cash flow projections. In this comparison, there are a few notable differences between the two types of cash flow.

  • Levered free cash flow uses a change in net working capital (mathematically represented by the delta symbol) as part of the equation. Net working capital is the difference between assets and liabilities.
  • Unlevered free cash flow includes working capital but does not take into account the change in net working capital. Although subtle, this difference can change the final calculation.

Both formulas include capital expenditures which typically take the form of capital investments that are used to grow and sustain the business.

5. Reason to Track Each Type of Cash Flow

Just as each business is unique, so is the reasoning behind why a company wants to showcase free cash flows as part of its balance sheet.

Many investors and finance professionals calculate levered free cash flow (LFCF) to prove how much potential exists for the business to expand and scale. It is a measure of profitability, sustainability, and growth. If a business struggles to stay afloat after accounting for recurring expenses, it is less likely to make positive investments in its future goals. 

On the other hand, the reason that some businesses showcase unlevered free cash flow is to inflate the financial picture in order to make a good impression on investors. Although this may not always be the case, it is certainly true that cash flow looks strongest before debt payments are made.

6. Importance to Financial Health

When it comes to the financial stability of a company, many accounting metrics are important. While free cash flows are just one piece of the puzzle, levered and unlevered cash flows can illustrate different things.

Levered free cash flow is often considered more important for determining actual profitability. It's a better indicator of financial health. This is because a business is liable for paying its debts and expenses in order to generate a profit.

Unlevered free cash flow is important to financial health because it highlights the gross cash amount. As long as a company isn't simply using UFCF to inflate its standing to investors, this can still be crucial for activities like budgeting and forecasting.

7. Unique Disadvantages

Every cash flow metric should have a purpose. Business leaders must know why they are using or relying on certain figures to make important decisions. With this in mind, there are some unique disadvantages when using the different types.

The disadvantages when using unlevered free cash flow are:

  • Without the proper motive, it can easily be inflated
  • Manipulating numbers could be more likely in this calculation
  • It may contribute to negative consequences like layoffs or delayed capital improvements

The disadvantages when using levered free cash flow are:

  • Calculating is occasionally more difficult due to constantly evolving numbers
  • Misrepresentation of debt as a negative factor, when in reality debt could indicate positive investment in company growth

What You Can Learn by Comparing Levered vs Unlevered

Many business owners want to know whether it's actually valuable or worthwhile to compare the differences between levered and unlevered free cash on a regular basis. The answer is yes! 

You can discover valuable metrics about the health of your business by staying in tune with these differences.

By comparing the numbers, you can get a better grasp on:

  • How a company's cash flow amounts look to potential investors
  • The ratio of "good" debt to "bad" debt (taking growth into consideration)
  • Regular earnings versus the amount of recurring expenses
  • The holistic financial health of an organization

Are There Any Similarities in Cash Flow?

Yes, there are some similarities on each side of the cash flow comparison chart. Both levered and unlevered free cash flow:

  • Appear on a company's balance sheet
  • Showcase enterprise value to potential investors and investment bankers
  • Provide a pulse check on the cash finances of a business or organization
  • Have advantages and disadvantages for regular use

Applying sound financial practices and working with a qualified accountant can ensure that your business relies on the type of free cash flow formula that works in a given situation or business model. This practice also provides transparency for any company with multiple equity holders and stakeholders.

More Accounting Resources for Businesses


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