Unlevered Free Cash Flow: Definition, Calculation, Importance & Limitations

Unlevered Free Cash Flow (UFCF) is a vital financial metric that measures the cash a company generates before accounting for interest payments on its debt. Unlike traditional cash flow calculations, UFCF provides a clearer picture of a company’s financial health by excluding debt-related expenses. 

To calculate Unlevered Free Cash Flow, use the following formula:

UFCF = EBIT × (1 − Tax Rate) + Depreciation and Amortization − Capital Expenditures − Change in Working Capital

In this formula,

• EBIT stands for Earnings Before Interest and Taxes. It is a measure of a firm’s profit that includes all expenses except interest and income tax expenses.
• Tax Rate: The corporate tax rate applicable to the firm.
• Depreciation and Amortization: Non-cash expenses that account for the reduction in value of tangible and intangible assets.
• Capital Expenditures (CapEx): Funds used by a company to acquire or upgrade physical assets such as property, industrial buildings, or equipment.
• Change in Working Capital: The difference between a company’s current assets and current liabilities over a period.

Unlevered Free Cash Flow is an essential metric for investors seeking to understand a company’s operational efficiency without the influence of its debt structure. By focusing on UFCF, investors can make more informed decisions and better assess the true value and health of a company. 

It is majorly used for the following reasons:

Assessing Operational Efficiency

UFCF allows investors to evaluate how efficiently a company is generating cash from its core business operations, independent of its debt structure. This makes it easier to compare companies within the same industry regardless of their financing choices.

This metric is especially useful for investors and analysts who want to assess a company’s operational performance without the influence of its capital structure.

Valuation Purposes

UFCF is crucial for valuation models, such as the Discounted Cash Flow (DCF) analysis. By discounting future UFCF to their present value, investors can estimate the intrinsic value of a company.

Investment Decision-Making

Investors rely on UFCF to make informed decisions. A higher UFCF indicates that a company is generating ample cash, which can be reinvested into the business, paid out as dividends, or used to pay down debt.

Unlevered free cash flow represents the total free cash flow generated by a company before any financial obligations are considered. It is the available cash flow that can be used to pay all stakeholders, including both debt and equity holders. 

Companies with substantial debt (high leverage) often report unlevered free cash flow to present a more favorable view of their financial health. This metric reflects how well a company’s assets are performing independently, as it excludes debt repayment costs. 

However, investors should also consider a company’s debt obligations, as firms with high leverage face a greater risk of bankruptcy.

Unlevered free cash flow (UFCF) can be a useful metric, but it has its limitations. Companies may manipulate UFCF figures by laying off employees, postponing capital projects, selling off inventory, or delaying payments to suppliers. 

Temporary Gains vs. True Business Health

Investors should be cautious and determine whether increases in UFCF are temporary or indicative of real growth. A closer look at the underlying factors is essential to understand the true financial health of the company.

Ignoring Capital Structure

One major drawback of UFCF is that it is calculated before interest payments, which means it overlooks the company’s capital structure. This can be misleading, as a firm with high debt may show a positive UFCF but have a negative levered free cash flow (LFCF) after accounting for interest expenses. This discrepancy could signal potential financial trouble ahead.

Potential Manipulation by Highly Leveraged Companies

Companies with significant debt loads may prefer to highlight UFCF to present a more favorable image. They might delay capital-intensive projects, postpone payments to suppliers, or reduce their workforce to improve UFCF figures. However, these actions may not reflect the company’s long-term financial stability.

InvestingPro offers detailed insights into companies’ Unlevered Free Cash Flow including sector benchmarks and competitor analysis.

UFCF excludes interest payments and provides a measure of cash flow that is unaffected by a company’s capital structure. In contrast, LFCF includes interest payments, reflecting the cash available to equity holders after all financial obligations are met.

Excluding interest payments allows for a more straightforward comparison of companies, as it removes the impact of different financing strategies. This is particularly useful for investors looking at companies with varying levels of debt.

A strong UFCF often signals robust operational performance and financial health, which can positively influence investor confidence and, consequently, the company’s stock price.

Industries with significant capital expenditures and varying debt levels, such as manufacturing, utilities, and technology, benefit from UFCF analysis as it provides a clearer view of operational efficiency.