How to Go From Unlevered FCF to Levered FCF

Free cash flow (FCF) serves as a fundamental metric in financial analysis, providing insight into a company’s financial health and operational efficiency. Within the realm of FCF, two distinct yet related measures exist: unlevered free cash flow (UFCF) and levered free cash flow (LFCF). Understanding the process of converting UFCF to LFCF is helpful for gaining a comprehensive view of a company’s cash-generating capabilities, especially from the perspective of its equity holders. This article will guide you through the components and calculations involved in this conversion.

Unlevered and Levered Free Cash Flow Overview

Unlevered free cash flow (UFCF) represents the cash generated by a company’s operations before considering any debt obligations. It signifies the cash flow available to all capital providers, including both debt holders and equity holders, before interest payments and principal repayments are made. This metric offers a clear picture of a company’s operational performance, independent of its capital structure. It is often referred to as “free cash flow to firm” (FCFF) because it reflects the cash available to the entire firm.

In contrast, levered free cash flow (LFCF) measures the cash remaining after a company has satisfied all its financial obligations, including interest on debt and mandatory principal repayments. LFCF, also known as “free cash flow to equity” (FCFE), represents the cash flow specifically available to the company’s equity holders. This metric provides a more comprehensive view of financial health by incorporating the impact of debt, showing what cash is truly available for dividends, share repurchases, or reinvestment after all debt-related commitments are met. The conceptual difference lies in UFCF focusing on enterprise-level cash generation, while LFCF focuses on the cash flow attributable solely to equity investors.

Identifying the Conversion Components

To transition from unlevered free cash flow to levered free cash flow, specific financial components related to a company’s debt structure must be identified and quantified. These components represent the cash outflows associated with servicing debt that are not accounted for in UFCF. Understanding each item and its source on financial statements is important for an accurate conversion.

Net interest expense is a primary component, representing the cost a company incurs for borrowing money, net of any interest income earned. This expense is typically found on the income statement. Interest expense is tax-deductible for corporations, meaning it reduces the company’s taxable income and, consequently, its tax liability. This tax benefit, often called the “tax shield,” must be considered when adjusting UFCF.

Mandatory debt principal repayments are another crucial adjustment. These are the contractually required payments of the original loan principal that reduce the outstanding debt balance over time. Unlike interest expense, which is an income statement item, principal repayments are cash outflows reported under financing activities on the cash flow statement. Only required payments are subtracted in this conversion, not optional or discretionary debt paydowns.

Other financing cash flows related to debt may also need to be considered, although they are less common adjustments than interest and principal repayments. These could include certain lease payments that are treated as debt obligations, or the net effect of debt issuance and repayment activities. Information on these items can typically be found within the financing activities section of the cash flow statement or its notes.

Calculating Levered Free Cash Flow

The calculation of levered free cash flow (LFCF) systematically incorporates the debt-related cash outflows that were identified previously, starting from unlevered free cash flow (UFCF). This procedural application allows for a precise determination of the cash available to equity holders.

Levered Free Cash Flow = Unlevered Free Cash Flow – After-Tax Net Interest Expense – Mandatory Debt Principal Repayments +/- Other Debt-Related Financing Cash Flows.

To apply this formula, the first step involves adjusting the net interest expense for its tax deductibility. Since interest expense reduces a company’s taxable income, the actual cash cost of interest is lower than its stated amount. The after-tax net interest expense is calculated by multiplying the net interest expense by (1 – corporate tax rate). This adjusted amount reflects the true cash outflow for interest after considering the tax savings.

Following the adjustment for after-tax net interest expense, mandatory debt principal repayments are directly subtracted from the remaining cash flow. These are the non-discretionary payments that a company is contractually obligated to make to its lenders to reduce the outstanding principal balance of its loans. Unlike interest, principal repayments do not offer a tax shield, so they are subtracted at their full value. These payments are distinct cash outflows that reduce the cash available to equity holders.

Finally, any other relevant debt-related financing cash flows are incorporated. These adjustments typically capture the net effect of any non-interest, non-principal cash movements related to debt, such as the net proceeds from new debt issued or the cash used for capital lease obligations. The net impact of these activities further refines the cash flow figure to arrive at the precise levered free cash flow.

Interpreting Levered Free Cash Flow

Levered free cash flow (LFCF) provides significant insights into a company’s financial standing from the perspective of its equity investors. LFCF represents the actual cash flow available to a company’s equity holders after all operating expenses, reinvestment needs, and debt obligations are satisfied. This metric directly indicates the funds a company has at its disposal for distributing dividends, repurchasing shares, or making further investments that benefit shareholders.

A consistent and positive LFCF demonstrates a company’s ability to cover operational costs and debt servicing, generating surplus cash for its owners. This indicates financial strength and a manageable debt structure. Conversely, a negative LFCF signals insufficient cash to meet financial commitments to debt holders and still have funds for equity holders. This situation could arise from high debt service costs, significant capital investments, or poor operational performance.

LFCF offers a perspective that unlevered free cash flow (UFCF) does not, by reflecting the impact of a company’s debt burden on its equity value. While UFCF provides a picture of overall business cash generation, LFCF directly shows how financing decisions affect cash available to equity investors. For equity holders, LFCF is a more direct and relevant measure of profitability and capacity to return value. The relationship between LFCF and UFCF can also reveal the extent of a company’s financial obligations and whether its debt levels are healthy and manageable.