Unlevered vs. levered free cash flow: Key differences and when to use them

As a small business owner, understanding your company’s cash flow is critical to maintaining financial health. When using your cash flow statement to analyze your financial health, you can track either levered free cash flow (LFCF) or unlevered free cash flow (UFCF).

These terms could be foreign to you, but we’re here to explain the differences between unlevered vs. levered free cash flow so you can better understand how to apply them to your business.

• What is unlevered free cash flow?
• What is levered free cash flow?
• Difference between levered and unlevered free cash flow
• Why you should compare levered and unlevered cash flows
• Limitations of unlevered and levered free cash flow
• Calculating unlevered vs. levered free cash flow
• Streamline your accounting and save time

What is unlevered free cash flow?

Unlevered free cash flow refers to the cash flow a business has available before satisfying its interest and other debts. In other words, it’s what you have before levered cash flow—the funding left after meeting financial obligations. Like levered cash flows, you can find unlevered cash flows on the balance sheet.

Unlevered cash flows provide a look at the company's enterprise value, which is a measure of the company’s total value. Enterprise value goes more in-depth than equity market capitalization since it considers both short-term and long-term debts and can show what a company is actually worth.

What is levered free cash flow?

Levered free cash flow projects the cash flow after removing interest expenses, capital expenditures, operational expenses, and taxes. Levered cash flows attempt to directly value the equity value of a company’s capital structure.

Essentially, levered free cash flow demonstrates a company’s cash flow after it satisfies its financial obligations and provides an accurate look at a company’s financial health and the amount of available cash. You can find levered free cash flows on the balance sheet.

Difference between levered and unlevered free cash flow

To better understand the difference between unlevered vs. levered free cash flow, let’s look at some key differences between the two. 

Formulas

The first difference between unlevered vs. levered free cash flow is the formula. The equation for levered free cash flows is:

LFCF = EBITDA – change in net working capital – CAPEX – mandatory debt payments 

The formula for unlevered free cash flow is: 

UFCF = EBITDA – CAPEX – working capital – taxes 

In these formulas, EBITDA represents your company’s “Earnings Before Interest, Taxes, Depreciation,” and CAPEX represents your capital expenditures, which is the money used to fund daily business activities. 

As you can see, the equation for unlevered free cash flow is less extensive than the one for levered free cash flow. That’s because the levered free cash flows equation subtracts debt and equity to yield operating cash only, while unlevered free cash flows do not.

So, how does this change for startups, small businesses, and investors? 

For startups, they usually depend on outside funding and may not generate much revenue in the early stages. That’s why UFCF is key — it shows your business’s core profitability before debt payments. Even if your startup has negative UFCF due to high startup costs, knowing how to calculate unlevered free cash flow for startups can help you explain your company’s potential to investors.

For small businesses, they focus on staying financially stable and paying their bills. In this case, LFCF is important because it shows how much cash is left after covering all expenses, including debt payments. For example, businesses with equipment loans or property debt must calculate LFCF to ensure they’re not overspending and can meet financial obligations.

When it comes to levered vs. unlevered cash flow for investors, they look at both to judge a company’s financial health.

• UFCF: They use it to value a business as a whole since it excludes debt.
• LFCF: They use it to focus on equity value and how debt impacts cash flow.

Expenses

One of the main differences between levered and unlevered free cash flow is how they treat expenses. Levered cash flows factor in expenses, such as operating expenses, debt payments, interest expenses, and taxes. 

In contrast, unlevered cash flows do not factor them in. Essentially, unlevered free cash flows are what you have before expenses and levered cash flows are what you have after. 

Reasons for tracking

So why should you track levered and unlevered free cash flows? Here are a few reasons why it matters to keep tabs on these metrics.

• Determine operating cash flow: Levered free cash flow (LFCF) helps businesses with a healthy amount of debt and working capital determine how much operating cash flow is available for expansion. 
• Keep an eye on debt impact: LFCF can go negative if your company has significant debt holders. While not ideal, a temporary negative LFCF could just mean you've invested heavily and need time to see returns.
• Improve budgeting and efficiency: Your company can utilize unlevered free cash flows (UFCF) when setting up your annual budgets to determine whether or not your departments are using their funding effectively. If UFCF levels are too low, there’s a good chance your company will fail to satisfy its debts and, in the long run, face bankruptcy.
• Make your business attractive to investors: Your company may track UFCF to paint the business in a better light to shareholders and potential buyers. The firms that carry significant debt tend to report unlevered cash flow instead of levered cash flow. As a result, your company may appear more successful and solvent than it truly is, demonstrating a higher amount of working capital.

Uses

Unlevered free cash flow is useful for investors and prospective buyers. When investors purchase a company, one of their goals is to pay off debts to enhance the business’s long-term market value. Unlevered free cash flow reveals how much capital will be available after making interest payments and paying down the net debt balance.

Levered free cash flow is also useful for investors and prospective buyers, but instead, they use it to make investment decisions and find ways to make improvements since it shows how much cash your business has to expand. In some ways, levered cash flows are seen as the more reliable method of financial modeling as they are a better indicator of a company’s future profitability. 

Here’s an example: Imagine an investor evaluating two tech startups — Company X and Company Y — during an economic downturn, both valued at $10 million.

Company X generates $2 in unlevered free cash flow, while Company Y generates $1.5 million in unlevered free cash flow. At first glance, Company X may be more attractive since it generates more cash from its operations ($2 million vs. $1.5 million). However, when looking at the levered free cash flows, the investor sees that Company X has $5 million in debt and Company Y has no debt.

During an economic downturn, the investor may choose Company Y despite its lower UFCF because they have no debt, and all the cash flow is available for reinvestment, savings, or expansion. Company X has a higher UFCF, but its $5 million debt reduces its LFCF. This adds financial risk and leaves less cash available after making mandatory debt payments.

Financial health importance

As you can see, levered free cash flow provides a look at your company's “present value” and an accurate view of your financial health, which allows you to measure your operating income. 

Unlevered free cash flows can help with budgeting and forecasting, as it shows the gross cash flow amount. This allows you to better compare the value of different investments and businesses, as some might have a higher interest expense and others don’t.

Why you should compare levered and unlevered cash flows

It’s useful for a business to regularly distinguish its levered and unlevered free cash flows. Let’s look at a few reasons why this is the case.

Gauge business health

While a smaller gap between LCF and UFCF indicates that fewer funds are available for investment and expansion, a more significant difference suggests a robust and healthy business.

Assess debt impact

Additionally, the difference between unlevered and levered free cash flow can reveal whether your business has taken on too much debt. If your company is earning less than it’s paying out in expenses for a prolonged period, the odds are good that your business is in trouble.

Support investor evaluations

When evaluating your company, investors may ask to see unlevered and levered cash flows. Ideally, you want to show investors unlevered cash flow projections, as this will paint your business in a better light. Still, owners and investors shouldn’t jump to conclusions if levered free cash flow is negative or very low for a single period. As mentioned, this could mean nothing more than taking on a healthy amount of debt to expand your business.

Make informed financial decisions

The most important thing to consider regarding levered and unlevered cash flows is that you should conduct these analyses on your own. Doing so can give you a better look at your company’s financial health. You should look for levered and unlevered cash flow trends before making important decisions regarding your company’s financial future.

Which is better to use?

Choosing between levered and unlevered free cash flow depends on what you want to understand about your business’s financial position. 

In short, use unlevered free cash flow when you want to get a clear picture of your business’s core profitability and value, especially for investors. On the other hand, use levered free cash flow when you want to see how much cash is left after paying debts, which helps you understand if you have funds to expand, pay shareholders, or reinvest in your business.

Limitations of unlevered and levered free cash flow

Both unlevered and levered cash flow have their strengths, but they also have limits. Take a look at the specific challenges each one presents and how they might impact your analysis.

Limitations of unlevered free cash flow

Here are some of the limitations of using unlevered free cash flow (UFCF):

• Doesn’t include debt obligations: UFCF doesn’t account for costs like interest payments or debt repayments, which means it doesn’t show the full scope of your financial responsibilities.
• Can overstate financial health: UFCF can sometimes overstate your business's financial health by excluding debt obligations.
• Lacks insight into shareholder value: Since UFCF excludes financing costs, it doesn’t reveal how much cash is actually available for shareholders or reinvestment.

Limitations of unlevered free cash flow

Here are some limitations of using levered free cash flow (LFCF):

• Highly affected by debt levels: LFCF is heavily influenced by your company’s debt and interest payments. If these numbers fluctuate, it can make LFCF harder to track consistently.
• Can show negative cash flow: Businesses with high debt can report negative LFCF, even if their operations are profitable. This might reflect a focus on repaying loans rather than poor performance, but it can still raise red flags for investors.

Calculating unlevered vs. levered free cash flow

As mentioned earlier, the formula for unlevered free cash flow is: 

UFCF = EBITDA – CAPEX – working capital – taxes 

And the equation for levered free cash flows is:

LFCF = EBITDA – change in net working capital – CAPEX – mandatory debt payments 

So, how do you calculate each one? Let’s look at the steps you need to take.

Unlevered free cash flow calculation

Follow these steps to calculate UFCF:

• Step 1: Start with EBITDA (earnings before interest, taxes, depreciation, and amortization). Find EBITDA on your income statement or calculate it by adding back interest, taxes, depreciation, and amortization to net income. It’s the revenue remaining after subtracting operating costs, excluding interest, taxes, and non-cash expenses like depreciation and amortization.

• Step 2: Subtract capital expenditures (CAPEX). Find CAPEX on your cash flow statement under “Cash Flows from Investing Activities.” CAPEX includes money you spend on physical assets like equipment, buildings, and other infrastructure.

• Step 3: Subtract changes in working capital. Calculate the change in working capital by finding the difference in current assets and current liabilities from the beginning to the end of the period (e.g., year or quarter). If working capital increases, cash flow decreases, and vice versa.

• Step 4: Subtract taxes. Subtract the amount you owe in taxes.

Imagine your company has the following financial data for the year:

• EBITDA: $500,000
• CAPEX: $100,000
• Beginning working capital: $50,000
• Ending working capital: $70,000
• Change in working capital: $20,000 ($70,000 - $50,000)
• Taxes: $60,000

When you plug these numbers into the formula, it should look like this:

$500,000 (EBITDA) - $100,000 (CAPEX) - $20,000 (change in working capital) - $60,000 (taxes) = $320,000 (UFCF)

Levered free cash flow calculation

Follow these steps to calculate LFCF:

• Step 1: Start with EBITDA. As with UFCF, begin with EBITDA from your income statement.

• Step 2: Subtract changes in net working capital: Calculate changes in net working capital as described above, using beginning and ending balances for the period. Adjust this amount based on whether working capital has increased or decreased.

• Step 3: Subtract CAPEX. As before, locate CAPEX in the cash flow statement and subtract this to account for necessary investments in physical assets.

• Step 4: Subtract mandatory debt payments. Determine the necessary interest and principal payments on any debts, such as loans or bonds. Then, subtract these required payments from your cash, as they reduce the available funds for equity holders.

Suppose your company has the following financial data for the year:

• EBITDA: $500,000
• Beginning working capital: $50,000
• Ending working capital: $70,000
• Changes in net working capital: $20,000
• CAPEX: $100,000
• Mandatory debt payments: $80,000 (includes both interest and principal payments)

When you take the numbers and put them into the formula, it should turn out like this:

• $500,000 (EBITDA) - $20,000 (change in working capital) - $100,000 (CAPEX) - $80,000 (mandatory debts payments) = $320,000 (LFCF)

Streamline your accounting and save time 

In the business world, cash is king, and a lack of liquid money can leave a company unable to pay for employee salaries and other expenditures. When you start running a business, you need to pay much more attention to in-depth financials like unlevered vs. unlevered free cash flow.

Proper financial management for small businesses will put you in a better position to secure loans and grow your company. Using accounting software can give you a quick look at everything you need to know about your company’s health and better track your finances.