Unlevered Free Cash Flow: What is it and How to Calculate?

Unlevered free cash flow is an important tool for investors looking to understand the financial performance of a company. LPas are more often than not equity investors, meaning they invest in companies rather than buying and selling individual securities. However, that also means that LPs need information that goes beyond just how much money a company makes or spends.

Unlevered free cash flow takes into account the operating cost of capital in order to give an investor a sense of how much cash the business can actually reinvest without having to take on any additional debt or equity financing. It doesn’t take into account things like interest payments and tax deductible expenses, but those factors only serve to muddy the water when trying to understand the health and potential of an operation. If you’re not sure about what unlevered free cash flow is or how it might impact your investment decisions, read through this article for more details.

 

What is Unlevered Free Cash Flow?

Unlevered free cash flow is the amount of cash a company generates without having to factor in the cost of financing the business through additional debt or equity. It’s a measure of operational performance that takes the cost of capital into account in order to help an investor understand how much cash a company can actually reinvest in the business without having to raise additional capital.

Basically, the cost of capital is the amount of money that it costs a company to access the capital they need to operate. For example, if you put a financing structure in place where debt costs 5% and equity investments cost 10%, you’re using the cost of capital to determine how much you need to raise from debt and equity.

Unlevered Free Cash Flow

 

How to Calculate Unlevered Free Cash Flow

Unlevered free cash flow is calculated in the same way that you would calculate any type of cash flow statement - the difference between operating profit and capital expenditures. You then subtract any required debt repayments and add any excess cash that’s been put into a revolving line of credit or other financing mechanism.

 Operating profit minus capital expenditures equals cash flow from operations. You then subtract any debt repayments and add any excess cash on line of credit to arrive at unlevered free cash flow. Keep in mind that you’ll need to look at both the net income and the cash flow statement: net income will give you the profit figure, while the cash flow statement will tell you how that profit was used in the business.

 

Why is Unlevered Free Cash Flow Important?

Unlevered free cash flow is important because it helps an investor understand how much debt the company is carrying: it gives you a sense of how much debt the company needs to run the operation and how much equity financing is required. If a company needs to continually raise money to fund operations, that’s a sign that the company might not be very profitable.

 Companies that aren’t very profitable will have to turn to debt or equity financing to keep operations afloat. This is much like taking out a car loan or a mortgage: you’re using future cash flows to pay off the debt today.

 

Limitations of Unlevered Free Cash Flow

One of the biggest limitations of unlevered free cash flow is that it ignores external factors that might impact the financial health of the company. For example, a company might have positive unlevered free cash flow but still be in danger of defaulting on their debt payments because of external factors like interest rates or the overall health of the economy.

Unlevered free cash flow also doesn’t take into account tax deductions or interest payments, which can make it harder to compare companies. For example, a company might have negative unlevered free cash flow but still be profitable thanks to tax deductions or other non-operational expenses that are taking out of the profits but not cash flow.

 

Understanding Unlevered Cash Flow

When people talk about unlevered cash flow, they’re actually talking about cash flow from operations minus capital expenditures. It’s a key metric for understanding the health of a company’s operation and their ability to generate cash. If a company has negative cash flow from operations but positive capital expenditures, they’re basically paying more to run the operation than they’re taking in.

This might seem counterintuitive, but it’s actually a very real scenario. Capital expenditures can include things like new equipment, renovations, or even the cost of buying another company. If a company spends more on capital expenditures than they make in operational cash flow, they’re taking a loss on operational cash flow.

 

The Basics of Unlevered Free Cash Flow

Unlevered free cash flow is an important metric for investors to understand the health of a business. However, it’s important to note that it doesn’t necessarily tell you whether a company is a good investment or not.

Companies can have positive or negative unlevered free cash flow and still be a good or bad investment, respectively. So how do you determine if a company is a good investment or not? You have to take into account a number of different metrics and financial ratios, including the company’s debt-to-equity ratio, net profit margin, and price to earnings ratio (PE).

 

What does unlevered free cash flow tell us?

Unlevered free cash flow doesn’t just tell you how much cash a company is generating, it also gives you an idea of how much debt they’re carrying to operate the company. A company with negative unlevered free cash flow is either paying down debt or acquiring new debt, which could be a sign that they’re being aggressive with their debt financing. Negative unlevered free cash flow might also be due to large capital expenditures, which generally aren’t as profitable as using debt to fund operations.

However, companies that are growing or operating in industries that require more capital expenditures tend to have negative unlevered free cash flow until they have the money to fund operations through debt.

 

Bottom line

When you’re looking at a company and trying to understand their financial performance, it’s important to use metrics like unlevered free cash flow. It takes everything into account, from capital expenditures to debt payments, and helps you understand the overall financial health of the company.

It’s not just important for investors, either: it’s also useful information for anyone trying to understand the health of a particular industry. After all, the best way to understand how an industry is doing is to look at the financial performance of the companies operating in that industry.

 

Financial Modeling Skills Course

Date
2022-07-30