How to Calculate Unlevered Free Cash Flow

Unlevered Free Cash Flow (UFCF) is a financial metric representing the cash generated by a company’s operations before considering any interest payments to debt holders. This measure provides insight into a company’s ability to generate cash from its core business activities, independent of its capital structure. It is a valuable tool for analysts and investors seeking to evaluate a business’s operational performance and its potential for expansion, offering a clear view of cash available to all capital providers. UFCF is frequently employed in valuation methodologies, particularly in discounted cash flow (DCF) analyses, to assess a company’s intrinsic value.

Understanding the Building Blocks

Earnings Before Interest and Taxes (EBIT)

Earnings Before Interest and Taxes (EBIT), also known as operating income, is a starting point for UFCF calculation. It reflects a company’s profit from its primary business activities before accounting for financing costs or taxes. This figure is found on a company’s Income Statement.

Tax Rate

The tax rate applied to a company’s operating income helps determine the after-tax profit from core operations. Companies use an effective tax rate, which accounts for federal, state, and local income taxes. This rate is crucial for calculating the Net Operating Profit After Tax (NOPAT).

Depreciation and Amortization (D&A)

Depreciation and Amortization (D&A) represent non-cash expenses that account for the decrease in value of tangible and intangible assets over their useful lives. Depreciation applies to physical assets, while amortization applies to intangible assets. Since these are non-cash charges, meaning no actual cash leaves the business, they are added back to earnings in cash flow calculations. These figures can often be found on the Income Statement or explicitly stated on the Cash Flow Statement.

Capital Expenditures (CapEx)

Capital Expenditures (CapEx) are funds a company spends to acquire, upgrade, or maintain long-term physical assets, such as property, plant, and equipment. These investments are necessary for a business’s continued operation and growth. CapEx is reported under the investing activities section of a company’s Cash Flow Statement.

Changes in Working Capital

Changes in Working Capital reflect fluctuations in a company’s short-term assets and liabilities from daily operations, excluding cash and debt. This includes items such as accounts receivable, accounts payable, and inventory. This change is presented in the operating activities section of the Cash Flow Statement.

The Calculation Process

The calculation of Unlevered Free Cash Flow combines the financial components to arrive at the cash available to all capital providers. The process begins by determining the Net Operating Profit After Tax (NOPAT). NOPAT represents the company’s after-tax profit from its core operations, unaffected by its debt structure. It is calculated by multiplying Earnings Before Interest and Taxes (EBIT) by (1 minus the effective tax rate). For example, if a company’s EBIT is $100 million and its effective tax rate is 21%, NOPAT would be $100 million multiplied by (1 – 0.21), resulting in $79 million.

After calculating NOPAT, non-cash expenses like Depreciation and Amortization (D&A) are added back. D&A are non-cash charges that reduce reported earnings but do not involve an outflow of cash. If a company had $10 million in D&A, this amount is added to the NOPAT.

Next, Capital Expenditures (CapEx) are subtracted. CapEx are investments in property, plant, and equipment required to maintain or expand the company’s operational capacity. These expenditures represent a direct cash outflow. For example, if the company spent $15 million on CapEx, this amount would be subtracted from the previous total.

Finally, adjustments are made for changes in non-cash working capital. An increase in non-cash working capital (such as a rise in inventory or accounts receivable) indicates cash is being tied up in operations, reducing free cash flow. Conversely, a decrease in non-cash working capital (such as a reduction in inventory or an increase in accounts payable) suggests cash is being freed up, which increases free cash flow. If working capital increased by $5 million, this amount would be subtracted. Unlevered Free Cash Flow is derived by taking NOPAT, adding back D&A, subtracting CapEx, and then adjusting for changes in non-cash working capital.

Refining the Calculation

Refining the Unlevered Free Cash Flow calculation involves adjusting for items that might distort a company’s recurring operational cash generation. Non-recurring items, such as one-time gains or losses from asset sales or legal settlements, are excluded from the calculation. This ensures that UFCF reflects cash flow from ongoing, sustainable business activities, providing a more accurate basis for valuation.

Accounting treatments can influence the inputs to the UFCF calculation. For example, the adoption of ASC 842 for lease accounting changed how leases are presented on financial statements. Under this standard, both operating and finance leases are recognized on the balance sheet. This can affect how certain cash flows are categorized. The goal of these refinements is to ensure that the calculated Unlevered Free Cash Flow truly represents the cash generated by the business’s core activities, available to all its long-term capital providers.