How to Calculate Levered Free Cash Flow

Levered Free Cash Flow (LFCF) represents the cash a company generates that is available to its equity shareholders after all operating expenses, taxes, and debt obligations. It provides a clear view of a company’s financial health for investors. Understanding LFCF is important for evaluating a company’s capacity to pay dividends, repurchase shares, or reinvest in its growth without external financing. It offers insight into the sustainability of operations and ability to manage financial commitments.

Key Financial Statement Inputs

Calculating Levered Free Cash Flow requires specific information from a company’s primary financial statements: the Income Statement, Balance Sheet, and Cash Flow Statement.

The Income Statement summarizes revenues and expenses over a period. It provides figures such as Revenue (total income from sales), Cost of Goods Sold (COGS – direct costs of production), and Operating Expenses like Selling, General, and Administrative (SG&A). Depreciation and Amortization, non-cash expenses reflecting asset cost allocation, are also found here. Interest Expense (cost of borrowing) and Income Tax Expense are reported on the income statement.

The Balance Sheet provides a snapshot of assets, liabilities, and equity at a specific point in time. It lists Property, Plant & Equipment (PPE), representing long-term tangible assets. Current assets include Accounts Receivable (money owed by customers) and Inventory (goods available for sale). Accounts Payable (money owed to suppliers) is a current liability. Short-term and Long-term Debt are also listed, indicating borrowing obligations.

The Cash Flow Statement details cash inflows and outflows. Capital Expenditures (CapEx), funds used to acquire, upgrade, and maintain physical assets, are in the investing activities section. Debt Repayments and Proceeds from New Debt, reflecting changes in a company’s financing structure, are in the financing activities section.

Calculating Unlevered Free Cash Flow

The first step is determining Unlevered Free Cash Flow (UFCF), which represents the cash flow generated by a company’s operations before accounting for any debt financing effects. This metric shows the cash available to all capital providers, both debt and equity holders, making it useful for comparing companies with different debt levels.

The calculation begins with Net Operating Profit After Tax (NOPAT). NOPAT is derived by taking a company’s operating income, also known as Earnings Before Interest and Taxes (EBIT), and adjusting it for taxes as if the company had no debt. It is calculated as EBIT multiplied by (1 minus the effective tax rate). This adjustment removes the tax benefits of interest expense, providing a pure view of operating profitability, which is essential for comparison.

Depreciation and Amortization (D&A), non-cash expenses, are added back. These expenses reduce reported profit on the income statement but do not involve an actual cash outflow in the current period. Adding them back to NOPAT converts the profit figure closer to a cash basis, reflecting that the cash for these assets was spent in a prior period when the assets were acquired.

Capital Expenditures (CapEx) are then subtracted. CapEx represents cash spent on acquiring or upgrading long-term physical assets, such as property, plant, and equipment. These investments are a direct cash outflow in the current period, reducing free cash flow and reflecting the cost of maintaining and expanding the business’s asset base.

Finally, adjustments are made for changes in working capital. Working capital is the difference between current assets and current liabilities, representing cash tied up in day-to-day operations. An increase in current assets like accounts receivable or inventory typically reduces cash flow, while an increase in current liabilities like accounts payable generally increases cash flow. The change in working capital reflects how efficiently a company manages its short-term assets and liabilities to generate or consume cash.

Adjusting for Debt-Related Items

After calculating Unlevered Free Cash Flow, specific adjustments related to debt are made to arrive at Levered Free Cash Flow. These adjustments account for the actual cash flows associated with a company’s financing structure, particularly its debt.

First, Net Interest Expense, adjusted for its tax deductibility, is subtracted. Interest expense is the cost a company pays for borrowing money. In the United States, interest paid on business debt is generally tax-deductible, meaning it reduces a company’s taxable income. Therefore, the after-tax interest expense is calculated by multiplying the interest expense by (1 minus the tax rate). This adjustment recognizes the actual cash cost of debt service after considering the tax shield, providing a more accurate reflection of cash outflow.

Second, Net Debt Repayments are adjusted. This figure represents the principal amount of debt repaid by the company, net of any new debt issued during the period. This is distinct from interest expense, as net debt repayments relate to the principal balance of the debt. This subtraction captures the cash used to reduce the company’s overall debt burden.

These two adjustments transform Unlevered Free Cash Flow into Levered Free Cash Flow by accounting for the cash flow implications of a company’s debt. The resulting figure provides a more accurate picture of the cash remaining for equity holders, as it reflects all mandatory cash outflows to both operating needs and debt service.

Bringing It All Together: The Levered Free Cash Flow Formula

The complete calculation of Levered Free Cash Flow integrates all components discussed, providing a comprehensive view of cash flow available to equity holders. The process systematically builds from operational profitability, adjusts for non-cash items and investments, and incorporates the impact of debt.

The calculation begins with Net Operating Profit After Tax (NOPAT). Depreciation and Amortization are added back. Capital Expenditures (CapEx) are then subtracted. Subsequently, the change in Net Working Capital is adjusted.

Next, debt-related adjustments are applied. The after-tax Net Interest Expense is subtracted. Net Debt Repayments are deducted.

The overall formula is: Levered Free Cash Flow = NOPAT + Depreciation & Amortization – Capital Expenditures +/- Change in Working Capital – Net Interest Expense (after tax) – Net Debt Repayments. This calculation provides investors and analysts with a clear understanding of the cash a business generates for its owners.