Why Unlevered Free Cash Flow is the Secret to Business Success

Unlevered cash flow is actually a measure of the cash flow of a company. That is used to measure the revenue generated by it after excluding all kinds of expenses. But all the ratios of debt and taxes are out of their range.

 As there is a specific process and formula for the calculation of unlevered cash flow. And to find it, you first have to know the earnings of a company in a specific period of time, besides taxes and interests. 

From this a lot of expenses could be excluded including all the money spent on maintenance, improving the assets of a company, and all others to find the exact amount of revenue in a specific period of time. 

It is considered a core aspect of business analysis. Where analysts and investors use it for their financial growth. Moreover, it is independent of all the debts ratio of a company and considered a separate aspect from it. Particularly it is considered a factor of determination to find the value of a company. 

Formula 

For the calculation of unlevered free cash flow, the following is the formula being used:

FCFF = EBIT*(1 -tax rate) + Depreciation & Amortization – Capital Expenditures +/- 

Changes in Net working capital 

Where 

• EBIT is the earning before interest rate and taxes 
• The tax rate is the marginal tax of a company 
• Capital expenditures are the amount being used for maintaining and improving the free assets of a company 
• Changes in networking capital are the ratio of fluctuations in the assets and liabilities of a company. 

Example 

If you are working on finding the unlevered cash flow of a company, then it is an example for illustration that you can use in your work. 

If we consider some of the following financial information of a company:

Revenue:                                          $1000000

Cost of goods being sold:                 $600000

Expenses in operation:                     $200000

Depreciation and amortization:        $50000

Capital expenses:                            $20,000

Changes in networking capital         $100,000

Marginal tax rate:                             30%

Now use the formula and put values in it:

UCF = ($1000000- $600000) * ( 1-0.30) + ( $50,000 – $20000) 

         = $140,000

It is a process by which the cash flow of a company could be generated easily by having these exact figures to know. 

Difference between levered and unlevered cash flow 

Levered and unlevered cash flows are different from each other in many aspects. Some of the main differences are enlisted as:

• While working on the levered cash flow, all the debt conditions are being taken into consideration. That is actually not a part of unlevered cash flow. 
• All the interest payments are a part of the consideration while working on the levered cash flow. Whereas conditions are opposite to it while dealing with the unlevered ones. 
• In the case of unlevered cash flow, cash does available to all the stakeholders of the firm. While levered cash flow is only available to equity holders after the deduction of debt financing. 
• It is the minimum risk factor in unlevered cash flow because there is no effect of changes in interest rates. Due to this, it is considered a good metric of evaluation to find the core of the company. 
• On the other hand, levered cash flow is highly affected by a very minor change in interest rates. That makes it very sensitive to any change in the market and financial conditions. 

Uses of unlevered free cash flow

Unlevered cash flow is an important part of business analysis and financial growth. Due to this, it is used for a variety of purposes. Some of its major uses of it are given:

• One of the major use of unlevered cash flow is company valuation and good for the representation of the intrinsic value of a company. Furthermore, could be analyzed discounted cash flow, and analysis of core operations of different departments of a company. 
• It is good to analyze the opportunity for investment. By which investors could know how a project is viable financially. And makes it able to compare it with other opportunities. 
• It is an important part as well for capital budgeting. To find the feasibility of capital expenditures. By getting a deep evaluation investors could know how much feasible is a particular project to give desired return. 
• It is good as well to assess the financial performance. That is good to know about changing trends with the capital structure. 

Limitations 

No doubt unlevered cash flow is a good metric to find financial performance. But there are some limitations as well. Some of these are enlisted as:

• All of this analysis is out of the debt conditioning of a company. That could be bad for the debt conditioning of a company. 
• Unlevered cash flow uses amortization and depreciation for the calculation of cash flow. Which could not represent the actual matrics of cash. 
• It adds all the changes in the net working capital. Due to this, all the operations of could not be estimated exactly. 
• Calculation of unlevered cash flow is sensitive to some assumptions. Including discount rate and growth rate. And very minor changes in them affect it adequately. 
• It is very difficult to find unlevered free cash flow in some companies. Especially for those who have some complex structure and multiple working departments. 
• This factor is limited to cash flow only. And does not describe the reasons for any changes in cash flow. 

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