Levered free cash flow is the cash a business has left in a period once it has covered its operating costs, funded its investment in fixed assets and working capital, and settled with its lenders. Because the debt has already been served, what remains answers to the common shareholders alone, which is what the word levered marks. The valuation literature calls the same measure free cash flow to equity, and the two names are used interchangeably.
The Build That Starts at Net Income
Start from the accounting measure of what the shareholders earned, then convert it to cash by taking out what the business had to reinvest and adding back what it borrowed.
FCFE = Net Income
- (Capital Expenditures - Depreciation)
- (Change in Non-cash Working Capital)
+ (New Debt Issued - Debt Repayments)That build is stated in Aswath Damodaran, NYU Stern, Free Cash Flow to Equity Discount Models, which describes the result as the cash flow available to be paid out as dividends or stock buybacks. Each line does one job, and two of them are commonly mishandled.
Capital expenditures come out because they are cash leaving the business, and depreciation and amortization are added back in because they are non-cash charges. The difference between the two is referred to as net capital expenditures, and it is usually a function of the growth characteristics of the firm, with high-growth firms tending to have high net capital expenditures relative to earnings and low-growth firms sometimes showing negative net capital expenditures (Aswath Damodaran, NYU Stern, Free Cash Flow to Equity Discount Models). Netting them is not a shortcut for the two separate adjustments. It is the same arithmetic collapsed into one line.
The working capital term is narrower than the balance sheet subtotal suggests. Increases in working capital drain a firm’s cash flows while decreases increase the cash available to equity investors, and since the interest is in cash flow effects, only changes in non-cash working capital are considered (Aswath Damodaran, NYU Stern, Free Cash Flow to Equity Discount Models). Leave cash inside the measure and the calculation starts subtracting the very thing it is trying to count. What the underlying subtotal contains is set out in net working capital.
Why the Debt Line Nets Rather Than Subtracts
This is the line that separates a levered figure from a careless one. Repaying the principal on existing debt represents a cash outflow, but the debt repayment may be fully or partially financed by the issue of new debt, which is a cash inflow, so netting the repayment of old debt against the new debt issues provides a measure of the cash flow effects of changes in debt (Aswath Damodaran, NYU Stern, Free Cash Flow to Equity Discount Models).
A business that repays a principal instalment and draws an equal amount of new borrowing has moved no cash to or from its shareholders. Subtract only the repayment and the measure reports a shortfall that never happened, which matters most in exactly the businesses that refinance regularly.
A Worked Example on Real Figures
Damodaran’s own worked case runs Nestlé’s reported year, in millions of Swiss francs.
Net income 5,763
Capital expenditures 5,058
Depreciation 3,330
Change in working capital 368
Net debt issues 272
FCFE = 5,763 - (5,058 - 3,330) - 368 + 272
= 5,763 - 1,728 - 368 + 272
= 3,939The figures and the result are stated in Aswath Damodaran, NYU Stern, Free Cash Flow to Equity Discount Models. Note what the reinvestment did to the answer: net capital expenditure and the working capital movement together removed more than a third of reported net income, and the modest net borrowing put only a little of it back.
The Shortcut When Financing Runs at a Fixed Mix
The calculation simplifies if the net capital expenditures and working capital changes are financed using a fixed mix of debt and equity. Where d is the proportion of those reinvestment needs raised from debt financing, the equity cash flow effect of capital expenditure needs becomes the negative of capital expenditures less depreciation multiplied by one minus d, and the working capital change is scaled the same way (Aswath Damodaran, NYU Stern, Free Cash Flow to Equity Discount Models).
FCFE = Net Income
- (Capital Expenditures - Depreciation) x (1 - d)
- (Change in Non-cash Working Capital) x (1 - d)The debt line disappears from the face of the formula because the assumption has already absorbed it. That is convenient in a forecast and wrong in a historical year where the actual borrowing did not follow the assumed ratio, so it belongs in a projection rather than in a report of what happened.
What the Figure Is Discounted At
A levered figure is discounted at a levered rate. Under the constant growth version of the model the value of the stock today is next year’s expected free cash flow to equity divided by the cost of equity less the perpetual growth rate in that cash flow (Aswath Damodaran, NYU Stern, Free Cash Flow to Equity Discount Models). The rate is the cost of equity on its own, not the blended rate, and how that rate is built is covered in cost of capital and priced in the CAPM equation.
Pairing this cash flow with a blended rate is the classic error, because the blended rate has already been reduced for the tax relief on debt that this cash flow has already paid out. The measure struck before any of that, and the reason its tax figure looks unusual, is in unlevered free cash flow.
Where the Circulating Formula Differs
Outside the valuation texts the term is usually written as a deduction from EBITDA, taking out working capital movements, capital expenditure and mandatory debt payments. It is not a different theory so much as a different set of choices, and no accounting standard or regulator fixes either version, a point the formula for FCF works through with the source that says so.
Two of those choices are worth naming. Starting at EBITDA rather than net income leaves interest and tax to be handled separately, and deducting mandatory repayments without adding new issuance drops the netting described above. Both can be defended for a credit question, where the point is whether contracted payments are covered. Neither produces the figure an equity valuation is asking for.
Where a Firm Meets the Number
Nothing in a close produces this figure. Every input is lifted off something already closed: net income off the income statement, capital expenditure and depreciation off the fixed asset roll-forward, the working capital movement off two balance sheets, and the debt lines off the financing section of the statement of cash flows. The quality of the answer is set by the classification decisions made during that close rather than by the arithmetic afterwards.
Three habits keep it defensible. Tie the debt movement to the loan schedule rather than to the balance sheet difference, since a difference hides a repayment and a redraw that cancelled. Exclude assets acquired by note or lease from capital expenditure, because no cash moved. And state which build you used beside the figure, because whoever asked for it, a lender, a buyer or the client’s own board, is likely working from a different one.
Common Questions
Is Levered Free Cash Flow the Same as Free Cash Flow?
No. Plain free cash flow is operating cash flow less capital expenditure, and the operating subtotal it starts from has already absorbed interest paid but has never touched principal or new borrowing, so it is neither a fully levered nor an unlevered figure. The route between the two, and the reason the plain measure carries no fixed definition, are in the formula for FCF.
How Do You Calculate Levered Free Cash Flow From EBITDA?
There is no authoritative EBITDA build for this measure, so the honest answer is that any version you use has to be described alongside the number. The defensible route is to reach the unlevered figure from EBITDA first, using the method in unlevered free cash flow, then take out after-tax interest and add net borrowing to arrive here. Starting at EBITDA and subtracting mandatory payments answers a coverage question instead.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a block of its own close and reporting work through a trial task so its reviewers stay on the judgment calls.
