Difference Between Levered and Unlevered Free Cash Flow

Levered vs Unlevered Free Cash Flow
 

Free cash flow provides a firm an indication of the amount of money a business has left for distribution among shareholders and bondholders. Free cash flow is generally calculated by adding cash flows from operating activities to cash flows from investing activities. There are two forms of free cash flow that are being discussed in this article; levered free cash flow and unlevered free cash flow. It is important to understand the difference between the two as it will provide a clear picture of which sources the company uses to raise funds. Understanding their difference can also help in evaluating the company’s cash flow statement and the firm’s operating, financing, and investing activities.

Levered Free Cash Flow

Levered free cash flow refers to the amount of funds that is left over once debt and interest on debt have been paid. It is important for a company to determine its levered cash flow because, this is the amount of funds that are left over for dividend payments, and expansion plans to obtain more debt and to invest in growth. Levered free cash flow is calculated as;

Levered free cash flow = Unlevered free cash flow – interest – principal repayments.

Levered free cash flow is closely monitored by banks and financial institutions since this is an indicator of the firm’s ability to stay financially afloat after meeting its debt commitments. The levered cash flow helps distinguish between firms that are economically sound, and firms which can barely meet their debt commitments (an indicator of high risk of failure).

Unlevered Free Cash Flow

Unlevered free cash flow refers to the amount of funds that a company has before interest payments and other obligations are met. Unlevered cash flow is reported in the firm’s financial statements and is a representation of the amount of funds that are available to pay for other operations before debt commitments are met. Unlevered free cash flow is calculated as;

Unlevered free cash flow = EBITDA – Capex – Working capital – Tax.

Unlevered cash flow does not provide a realistic picture of the firm’s financial situation as it does not shows the firm’s debt obligations, and instead shows the total amount of cash that remains for operational activities. Companies that are highly leveraged (have high amounts of debt), generally, report their unlevered free cash flow; however, investors, financial institutions, and stakeholders need to give more attention to the firm’s levered free cash flow as this shows the level of debt which provides a strong indication of the risk of bankruptcy.

Levered vs Unlevered Free Cash Flow

Levered and unlevered free cash flow are concepts that stem from the term free cash flow. Levered free cash flow shows the amount of funds that are left over once debt and interest on debt are paid. Unlevered cash flow is the amount of funds that are left over before paying interest. Levered free cash flow is a more concrete number to use in evaluating a firm as levels of debt are important in understanding the company’s risk of bankruptcy. The smaller the gap that the company has between its levered and unlevered cash flow, the smaller amount of funds that the firm has left over that is not needed to meet debt commitments. Therefore, a smaller gap could mean that the company is at financial risk, and needs to take steps to increase their revenue or deduce levels of debt.

Summary:

Difference Between Levered and Unlevered Free Cash Flow

• Levered free cash flow refers to the amount of funds that is left over once debt and interest on debt have been paid. It is calculated as; Levered free cash flow = unlevered free cash flow – interest – principal repayments.

• Unlevered free cash flow refers to the amount of funds that a company has before interest payments and other obligations are met. It is calculated as; Unlevered free cash flow = EBITDA – Capex – Working capital – Tax.

• Levered free cash flow is a more concrete number to use in evaluating a firm as levels of debt are important in understanding the company’s risk of bankruptcy.