Free cash flow is a measure of how much money is available to investors through the operations of the business after accounting for expenses of the business such as taxes, operational expenses and capital expenditures. Free cash flow comes in 2 forms, levered and unlevered:
Free Cash Flow is extremely useful in LBO modeling as it shows how much cash the company will have to pay off the debt used to finance the buyout. Unlevered FCF is the more commonly used of the two.
Free Cash Flow Calculation and Meaning
Free Cash Flow shows the amount of money which a firm is able to generate after taking into account asset expenditures. FCF is essential in order to increase the value of a firm, as without cash a firm is unable to innovate, pay off debt or perform takeovers. Additionally, free cash flow is used to perform intrinsic valuations such as a discounted cash flow analysis.
What is the Unlevered Free Cash Flow Formula?
Typically when someone is refering to free cash flow, they are refering to unlevered free cash flow which is the cash flow available to all investors, both debt and equity. When performing a discounted cash flow with unlevered free cash flow - you will calculate the enterprise value.
Free cash flow is calculated as EBIT * (1 - tax rate) + Depreciation + Amortization - change in net working capital - capital expenditures.
What is the Levered Free Cash Flow Model?
While unlevered free cash flow looks at the funds that are available to all investors, levered free cash flow looks for the cash flow that is available to just equity investors. It is also thought of as cash flow after a firm has met its financial obligations. When performing a discounted cash flow with levered free cash flow - you will calculate the equity value.
Levered free cash flow is calculated as Net Income (which already captures interest expense) + Depreciation + Amortization - change in net working capital - capital expneditures - mandatory debt payments.
Even if a company is profitable from a net income perspective and postive from an unlevered free cash flow perspective, the company could still have negative levered free cash flow. This could mean that this is a dangerous equity investment since equity holders get paid last in the event of bankruptcy.
- Capital Expenditure (CapEX)
- Cash Flow Statement (CFS)
- Earnings Before Interest & Tax (EBIT)
- Leveraged Buyout (LBO)