Unlevered free cash flow
Unlevered free cash flow (UFCF) is a measure of the cash flow available to all providers of capital in a business. It is calculated by taking operating cash flows and adjusting for changes in working capital, non-cash expenses and capital expenditures.
Example of Unlevered free cash flow
To illustrate how to calculate the UFCF, let's take an example of a company with an operating cash flow of $100 million, an increase in working capital of $10 million, and capital expenditures of $25 million. The calculation of the UFCF would be as follows:
UFCF = $100 million - ($10 million + $25 million)
UFCF = $65 million
Therefore, in this example, the UFCF for the company was $65 million. This figure indicates that the company has $65 million available to pay dividends or buy back stock.
Formula of Unlevered free cash flow
UFCF = Operating Cash Flow - (Change in Working Capital + Capital Expenditures)
The formula for calculating UFCF is relatively simple. It is derived from the operating cash flow and then adjusted for changes in working capital, non-cash expenses and capital expenditures. The operating cash flow is the amount of cash generated by the company's operations. This is then adjusted for changes in working capital, non-cash expenses and capital expenditures. Change in working capital is the difference between the current year's working capital and the previous year's working capital. Non-cash expenses are any expenses that do not involve cash outflows such as depreciation or amortization. Capital expenditures are investments made in assets such as buildings, equipment and inventory.
By subtracting these items from operating cash flow, the resulting figure is the UFCF, which is the cash flow available to all providers of capital in the business. This figure is important to investors as it allows them to compare the cash flows of different companies independent of their capital structure. Furthermore, it provides an indication of how much cash is available to pay dividends or buy back stock.
When to use Unlevered free cash flow
Unlevered free cash flow should be used when comparing companies of different capital structures or to better understand the cash flows of a company before debt is taken into account. It is also useful for investors who want to understand the cash flows of a company before taking into account the impact of the company’s debt.
Unlevered free cash flow can be used to value a company by discounting the expected future cash flows back to their present value. This can be done by calculating the cost of equity and then discounting the future cash flows by the cost of equity. This allows investors to value a company independent of its capital structure.
Steps of Unlevered free cash flow
The steps of calculating Unlevered free cash flow are as follows:
- Step 1: Calculate operating cash flow by taking the net income before taxes and adding back any non-cash expenses such as depreciation and amortization.
- Step 2: Calculate the change in working capital by subtracting the current period's ending working capital balance from the prior period's ending working capital balance.
- Step 3: Calculate capital expenditures by subtracting the current period's ending capital expenditures balance from the prior period's ending capital expenditures balance.
- Step 4: Calculate Unlevered free cash flow by subtracting capital expenditures and change in working capital from operating cash flow.
Advantages of Unlevered free cash flow
- The main advantage of UFCF is that it allows investors to compare the cash flow of different companies without taking into account their capital structure. This is helpful when comparing companies with different capital structures, as it eliminates the effect of leverage and allows investors to get a clearer picture of the company’s underlying cash flow.
- It also helps investors understand the company’s cash flow before any debt is taken into account. This is important for understanding how much cash the company has available to pay dividends or buy back stock.
- Additionally, UFCF can be used to assess the amount of cash a company has to fund future growth initiatives or make acquisitions. This can be especially helpful when evaluating companies with different capital structures.
Limitations of Unlevered free cash flow
Despite the advantages of using Unlevered Free Cash Flow, there are some limitations to consider. These include:
- It does not take into account changes in debt levels or how the debt is structured, meaning that it may not provide an accurate picture of the total cash flows available.
- It does not take into account the cost of capital, which can be important when making investment decisions.
- It does not take into account the effect of taxes, which can have a significant impact on the cash flows available to investors.
There are several approaches related to UFCF that can help investors better understand a company's cash flow. These include:
- Cash Flow to Equity (CFE): This approach looks at the cash flow available to equity holders after deducting the cost of debt service payments.
- Free Cash Flow to Firm (FCFF): This approach looks at the cash flow available to the entire firm, including debt holders, after deducting all capital expenditures.
- Free Cash Flow to Equity (FCFE): This approach looks at the cash flow available to equity holders after deducting all capital expenditures and debt service payments.
These related approaches allow investors to analyze a company's cash flows from different perspectives, giving them a better understanding of the company's financial position. By comparing these different cash flow measures, investors can gain insight into the company's ability to generate cash and pay dividends.
Unlevered free cash flow — recommended articles |
Distributable profit — Earnings per share — Return on equity (ROE) — Return on assets (ROA) — Net income — Operating earnings — Coverage ratio — Retention ratio — Market value ratios |
References
- Fernandez, P. (2007). Valuing companies by cash flow discounting: ten methods and nine theories. managerial Finance, 33(11), 853-876.
- Drake, P. P. (2005). What is free cash flow and how do I calculate it?. James Madison.