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 or unlevered free cash flow (LFCF and UFCF, respectively).
As a new small business owner, these terms could be foreign to you, but we’re here to explain the differences between levered and unlevered free cash flow so you can better understand how to apply them to your business.
What are discounted cash flows?
Before we dive deeply into the differences between levered and unlevered cash flows, it’s essential to understand what both these things are. Both levered and unlevered cash flows are considered discounted cash flows (DCF).
DCFs attempt to measure how much value a business creates. Many will argue that DCF is the best valuation method available because it acknowledges that the real value of a company is the future cash flows it provides to its owners or shareholders.
Those in corporate finance tend to use DCF analyses often. So do investment bankers, Wall Street brokers, academics and business development professionals.
As is the case with any valuation, you need a lot of assumptions to conduct a DCF analysis. If one component is off, you’ll see a wildly different valuation.
There are three primary components of a DCF analysis:
- Free cash flow projection, which is the amount of cash a company’s business operations will produce after paying for capital expenditures and operating expenses.
- Discount rate, which is the cost of capital for the business. This rate is similar to an interest rate on future cash inflows, converting them into dollar equivalents.
- Terminal value, which is the future value of the business at the end of the projection period.
Levered and unlevered cash flow projections come into play during the first portion regarding free cash flow projections. You can use either levered or unlevered funds for the free cash flow amount in your DCF analysis. The option that you choose will have a significant impact on your future valuation.
What is levered free cash flow?
Levered free cash flows project the cash flow after removing interest expenses, known as debt, and interest income, known as cash. Levered cash flows attempt to directly value the equity value of a company’s capital structure.
Essentially, levered free cash flows demonstrate a company’s cash flow after it has satisfied all of its financial obligations. Levered free cash flows are available on the balance sheet.
Why track levered free cash flow?
Using levered free cash flow to run your DCF analysis can be advantageous because it shows how much operating cash flow a business has to expand.
For instance, a company can have a negative levered free cash flow if it has significant debt holders. This type of financial performance isn’t ideal, but if it’s temporary, investors shouldn’t be too wary. It could mean nothing more than the company has made significant capital investments, and they have yet to begin paying it off. But, this may make equity holders a bit wary, as they would be the last to be paid in the event of bankruptcy.
So, in some ways, levered cash flows are seen as the more reliable method of financial modeling. They are a better indicator of a company’s future profitability. It only measures cash working capital and takes out non-cash expenses, so you gain a much better look at how much cash you have on hand.
How to track levered free cash flow
If you have a healthy amount of debt and net working capital, then you may want to consider using levered free cash flows for your DCF projections. You should be able to find all of the required information on your balance sheet. The equation for levered free cash flows is:
LFCF = net income + depreciation + amortization – change in net working capital – capital expenditures – mandatory debt payments
As you can see, LFCF provides you with a look at the “present value” of your company and an accurate depiction of your financial health. LFCF allows you to measure your operating income. Let’s take a look to see how levered free cash flows compare to their unlevered counterparts.
What is unlevered free cash flow?
Unlevered free cash flow — or sometimes just “unlevered cash flow” — refers to the free cash flow a business has available before it’s satisfied its interest and other debts. In other words, it’s what you have before levered cash flow — the funding left after financial obligations have been met. Like levered cash flows, you can find unlevered cash flows on the balance sheet.
Whereas levered free cash flows can provide an accurate look at a company’s financial health and the amount of cash it has available, unlevered cash flows provide a look at the enterprise value of the company.
Enterprise value is a measure of the company’s total value. Enterprise value is considered more in-depth than equity market capitalization, which measures the total value of a company based on relative size. Enterprise value considers both short-term and long-term debts and can show what a company is actually worth.
Why track unlevered free cash flow?
Unlevered free cash flow indicates the number of funds available before accounting for expenditures like debt and interest expenses. Because it affects the amount of cash a business has on-hand to pay its bills, unlevered free cash flow has a direct impact on internal accounting decisions.
In fact, companies often utilize UFCF when setting up their annual budgets and determining whether or not various department heads are utilizing their funding effectively. If unlevered cash flow levels are too low, there’s a good chance a company will fail to satisfy its debts and, in the long run, wind up facing bankruptcy.
Additionally, a company may track UFCF to paint the business in a better light to shareholders and potential buyers. The firms that carry significant debt — known as “highly leveraged” businesses — tend to report unlevered cash flow instead of levered cash flow because the former ignores asset-based debt. As a result, the company may appear more successful and solvent than it truly is, demonstrating a higher amount of working capital.
Of course, unlevered FCF isn’t only of value to business owners — it’s also useful for investors and prospective buyers. When investors purchase a company, one of their goals is usually to pay off debts to enhance the business’s long-term market value.
As a result, investors will want to know the unlevered free cash flow value, as this reveals how much capital will be available down the line after making interest payments and paying down the net debt balance.
How to track unlevered free cash flow
To find your company’s UFCF, you will first want to look at financial statements and calculate your company’s Earnings Before Interest, Taxes, and Depreciation (EBITDA). You can find all of the necessary information on your income statement.
Next, identify your capital expenditures (CAPEX), or the money used to fund daily business activities. You can find this information on the cash flow statement.
Finally, determine the value of your working capital, which is otherwise known as the difference between a company’s current assets and its current liabilities. This leaves you with an equation that looks like this:
UFCF = EBITDA – CAPEX – working capital – taxes
As you can see, the equation for unlevered free cash flow is not nearly as extensive as 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.
Why you should compare levered and unlevered cash flows
It’s useful for a business to distinguish its levered and unlevered free cash flows regularly. 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.
Additionally, the difference between unlevered and levered free cash flow can reveal whether the business has taken on too much debt. If a company is earning less money than it’s paying out in expenses for a prolonged period, the odds are good that the business is in trouble.
Investors may ask to see both unlevered and levered cash flows when evaluating your company. 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 previously, this could mean nothing more than taking on a healthy amount of debt to expand your business.
The most important thing to consider when it comes to 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 trends in levered and unlevered cash flow before making important decisions regarding your company’s financial future.
Using levered and unlevered cash flow for your business
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 start paying much more attention to in-depth financials like levered and unlevered cash flow.
Proper financial management for small businesses will put you in a better position to secure loans and grow your company. To better track your finances, you’ll want to make sure you use trusted accounting software. Gone are the days of managing your company’s finances in Excel. Using accounting software can give you a quick look at everything you need to know about your company’s health.