Unlevered free cash flow is a great way to look at the viability of a business, without taking debt and interest into account. Sometimes, a business's true value can be obscured if much of its cash flow is being eaten away by debt and not allowing the business to function properly. Unlevered free cash flow provides a clearer window and is an important tool for looking at a company with an unencumbered view.
What is unlevered cash flow?
Unlevered free cash flow (UFCF) measures the gross cash generated by a company, excluding debt and interest payments. It provides a clearer picture of how effectively a company operates without factoring in its capital structure. Analysts typically use UFCF to assess enterprise value (EV) in discounted cash flow (DCF) analysis since it standardizes cash flow across firms with varying debt levels.
The formula for calculating UFCF is:
UFCF = EBITDA - Capex - Change in Working Capital - Taxes
- EBITDA: Earnings before interest, taxes, depreciation, and amortization.
- Capex: Capital expenditures for assets like equipment or property.
- Change in Working Capital: Adjustments for changes in accounts receivable, accounts payable, and inventory.
- Taxes: Cash taxes paid during the period
Example:
UFCF = $500,000 - $100,000 - $20,000 - $80,000
UFCF = $300,000
Why UFCF matters
Why unlevered free cash flow matters
UFCF has many uses, but some of the most common include:
Fair comparisons between companies
UFCF is great for making fair comparisons between companies, no matter how much debt they carry. Since it excludes debt and interest payments, UFCF shows a business’s raw ability to generate cash from operations. For example, if you’re comparing two companies in the same industry, one heavily in debt and the other debt-free, UFCF lets you see how well each is performing without the numbers skewed by financing costs.
Measuring growth potential
UFCF highlights how much cash a company has available to grow or reinvest. Think of it as a measure of the company’s financial breathing room. For instance, a business with strong UFCF can expand operations, invest in new equipment, or even launch new products without worrying about debt payments eating into its resources. It’s like knowing how much extra money you have after covering essential expenses, giving you a good idea of what you might want to spend or invest money on.
Helps with business valuations
When analysts value companies, they often use UFCF in discounted cash flow (DCF) models to calculate enterprise value. This approach ignores debt, focusing instead on the company’s overall ability to generate cash. For example, if two companies generate the same UFCF but have different financing structures, the DCF model helps highlight their true operational value, giving investors a clearer picture of where to put their money.
That being said, while UFCF highlights operational strength, it doesn't consider the burden of existing debt. A highly leveraged company may have a healthy UFCF but struggle to meet its debt obligations, which could be an indicator of financial distress.
How investors use UFCF
How investors use UFCF
Now that you understand how UFCF works, you can use it as a practical tool for evaluating businesses or making informed investment decisions. If you’re an investor, UFCF helps you determine how efficiently a company generates cash from its operations without being influenced by its debt. For example, if two companies in the same industry report similar revenues but one has a much higher UFCF, that company is likely managing its operations and expenses more effectively.
For business owners or executives, UFCF is a valuable measure of financial health and growth potential. A strong UFCF can signal the ability to reinvest in the company; whether through purchasing new equipment, expanding facilities, or funding innovation. By tracking UFCF over time, businesses can identify trends, address inefficiencies, and make better strategic decisions.
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Example
Example of unlevered free cash flow: Steel Dynamics
Let’s consider a real-world example using Steel Dynamics (STLD -0.43%), a U.S. steel producer, to demonstrate how UFCF is calculated. Suppose the company reports the following financial metrics for a given year:
- EBIT (Operating Income): $2,000,000
- Tax Rate: 25%
- Change in Working Capital: $100,000
- Capex: $400,000
| Metric | Value ($) | |
|---|---|---|
| EBIT (Operating Income) | 2,000,000 | |
| Taxes (25% of EBIT) | -500,000 | |
| Change in Working Capital | -100,000 | |
| Capex | -400,000 | |
|
Unlevered Free Cash Flow (UFCF) |
1,000,000 |
Steel Dynamics’ UFCF of $1,000,000 reflects the cash available for all stakeholders before considering financing obligations, making it an important metric for evaluating its operational performance and financial health.
