Unlevered Free Cash Flow Formula
Cash flow is critical to every business, big and small. It represents the money you have coming in and going out.
Then we have free cash flow, which is the difference between those cash inflows and outflows. At its core, it tells you whether you’re profitable and can generate the capital needed to continue running your business.
Yet many SMBs fail because they can’t create the cash flow necessary to sustain their business. In fact, this is the reason 30% of small business ventures fail: the inability to generate a positive cash flow.
Cash flow is more complex than that, too. You have operating cash flow, discounted free cash flow, and both levered and unlevered free cash flow.
Below, we’ll be looking at unlevered free cash flow, what it is, why it’s important, and how to calculate it.
Unlevered free cash flow formula
Unlevered free cash flow = earnings before interest, tax, depreciation, and amortization - capital expenditures - working capital - taxes
What does unlevered mean?
Before we dive in, it’s helpful to understand what we’re talking about when we say “unlevered.” Unlevered means the business was funded on its own, without requiring small business loans, investors, or other external sources of capital. In cases where a small business does use external funding, those lenders have leverage, which is where we get the words levered and unlevered.
So, in this context, unlevered means the small business hasn’t borrowed any capital necessary to start and fund their operations. In other words, they completely own all of their capital and assets.
What is unlevered free cash flow?
Unlevered free cash flow is the cash flow a business has, excluding interest payments. Essentially, this number represents a company’s financial status if they were to have no debts.
Unlevered free cash flow is also referred to as UFCF, free cash flow to the firm, and FFCF.
Because it doesn’t account for all money owed, UFCF is an exaggerated number of what your business is actually worth. It can provide a more attractive number to potential investors and lenders than your levered free cash flow calculation.
Plus, companies fund differently, so UFCF is a way to provide a more direct comparison in cash flows for different businesses. It’s helpful when evaluating companies against one another. Likewise, each business could have a different payment structure and interest rate with their debtors, so UFCF creates a level playing field for comparative analysis.
Unlevered free cash flow vs. levered free cash flow
While unlevered free cash flow excludes debts, levered free cash flow includes them. Therefore, you’ll find that unlevered free cash flow is higher than levered free cash flow. Levered free cash flow assumes the business has debts and uses borrowed capital.
How to calculate unlevered free cash flow
The formula for UFCF is:
Unlevered free cash flow = earnings before interest, tax, depreciation, and amortization - capital expenditures - working capital - taxes
Abbreviated, you can write it as:
UFCF = EBITDA - CAPEX - change in working capital - taxes
Let’s define our variables:
- Earnings before interest, taxes, depreciation, and amortization: EBITDA is an alternative to simple earnings or net income that you can use to determine overall financial performance
- Capital expenditures: CAPEX are investments in property, buildings, machines, equipment, and inventory, as well as accounts payable and accounts receivable
- Working capital: the total current assets less total current liabilities
- Taxes: the amount owed in taxes
Unlevered free cash flow example
Now that we have our formula, we can put it to work with an example. Let’s say you operate a construction company. In your first year, your EBITDA was $150,000. That figure grew to $250,000 in your second year. Year 1 is also when you purchased all of your machinery for $275,000. Year 1’s working capital was $50,000, and $100,000 in Year 2. Taxes were $25,000 and $40,000 for the first and second year, respectively. Here’s what this all looks like:
Given all of that information, we turn back to our UFCF formula:
UFCF = EBITDA - CAPEX - change in working capital - taxes
Plugging in the numbers for Year 1 looks like this:
UFCF = 150,000 - 275,000 - 50,000 - 25,000 = -$200,000
And Year 2 looks like this:
UFCF = 250,000 - 0 - 50,000 - 40,000 = $160,000
You can see how UFCF can be a negative figure but not necessarily a negative implication about your business. Predictably, the first year required more CAPEX, but you were able to recuperate during the second year and generate a positive UFCF.
Moving forward with unlevered free cash flow
Unlevered free cash flow isn’t black and white. Negative numbers aren’t always bad — it’s more important to understand the why behind the metrics and note trends over time.
Plus, you don’t want to look solely at UFCF. There are other free cash flow formulas you can use to learn more about your business’s overall financial health. Here are some to start with next: