Unlevered free cash flow is the cash a business generates from its operations in a period, after the tax on its operating profit and after the reinvestment it makes in fixed assets and working capital, and before any payment to lenders. Because nothing has gone out to debt yet, the figure belongs to everyone who funded the business, lenders and owners alike, and that is what the word unlevered marks. It goes by a second name, free cash flow to the firm, and like every free cash flow measure it is non-GAAP: nothing in the accounting standards defines it, so it has to be assembled from statements that are already closed rather than read off one of them.
What Unlevered Marks Off
Leverage is the use of debt and other fixed-charge financing in a business’s funding mix, which is set out in financial leverage. This measure is struck before any of it. Free cash flow to the firm is the sum of the cash flows to all claim holders in the firm, including stockholders, bondholders and preferred stockholders, and since this cash flow is prior to debt payments, it is often referred to as an unlevered cash flow (Aswath Damodaran, NYU Stern, Firm Valuation: Cost of Capital and APV Approaches).
One consequence of that explains why the tax figure inside the build looks wrong at first. Free cash flow to the firm does not incorporate any of the tax benefits due to interest payments, and that is by design, because the use of the after-tax cost of debt in the cost of capital already considers this benefit and including it in the cash flows would double count it (Aswath Damodaran, NYU Stern, Firm Valuation: Cost of Capital and APV Approaches). The after-tax cost of debt is the debt leg of cost of capital. So the tax subtracted here is the tax on operating profit, taken as though the business borrowed nothing, and the deduction the business really claims is handled on the discount-rate side instead.
How Unlevered Free Cash Flow Is Calculated
The build starts at operating profit rather than at a cash subtotal.
FCFF = EBIT (1 - tax rate) + Depreciation - Capital Expenditure - Δ Working CapitalThat formula is stated in Aswath Damodaran, NYU Stern, Firm Valuation: Cost of Capital and APV Approaches. Each term does one job.
EBIT is earnings before interest and taxes, the operating profit line, defined alongside its better-known relative in EBITDA. Multiplying it by one minus the tax rate turns operating profit into an after-tax operating figure. That is not the same thing as the net operating profit or loss after taxes, NOPLAT, which is a slightly modified version of this estimate and removes any non-operating items that might affect the reported EBIT (Aswath Damodaran, NYU Stern, Firm Valuation: Cost of Capital and APV Approaches).
Depreciation is added back because it was deducted in reaching EBIT without any cash leaving. Capital expenditure is the cash actually spent on long-lived assets in the period, and it comes out because that spending is real. The last term is the movement in net working capital, which comes out when it grows, since cash tied up in receivables and inventory is cash the business no longer has.
A Worked Example
Say a company’s closed year produces the amounts below, on a stated tax rate, with one equipment purchase and one increase in working capital.
EBIT 900,000
Tax rate 21%
Depreciation 140,000
Capital expenditure 220,000
Increase in net working capital 45,000
EBIT (1 - tax rate) = 900,000 x 0.79 = 711,000
plus depreciation 851,000
less capital expenditure 631,000
less increase in net working capital 586,000
Unlevered free cash flow 586,000Interest never appears in that column. Add debt to the same business and the answer does not move, which is the whole point of the measure. Two companies with identical operations and different amounts of borrowing produce the same unlevered free cash flow.
Where the Figure Is Used
This is the cash flow stream a firm-level discounted cash flow valuation runs on. The FCFF valuation approach estimates the value of the firm as the present value of future FCFF discounted at the weighted average cost of capital, and the value of equity is then the value of the firm minus the value of the firm’s debt (CFA Institute, Free Cash Flow Valuation). The value it produces therefore answers to the whole capital structure, which is the frame enterprise value sets out, and it sits inside the income approach described in valuation.
What Unlevered Free Cash Flow Is Confused With
Levered Free Cash Flow
Levered free cash flow is what is left for common stockholders once lenders have been paid, and the valuation literature calls it free cash flow to equity. Which claimant each of the two measures answers to, and how an analyst reaches either one from the cash flow statement, are set out in the formula for FCF. What separates them arithmetically is one relation: FCFE = FCFF - Int(1 - Tax rate) + Net borrowing (CFA Institute, Free Cash Flow Valuation).
The whole difference is two debt items. After-tax interest comes out, new net borrowing goes in, and nothing about the operations changes. On the figures above, with a stated interest expense and no new borrowing:
Interest expense 60,000
Net borrowing 0
FCFE = 586,000 - (60,000 x 0.79) + 0
= 586,000 - 47,400
= 538,600Operating Cash Flow Minus Capital Expenditures
That is the plain free cash flow measure, and it is not an unlevered figure. It starts from the operating subtotal of the statement of cash flows, which is struck after interest paid, one of the operating payment classes the standard names separately, as the operating cash flow formula sets out. The route from that subtotal across to this one, and the reason the plain measure has no uniform definition, are both worked through in the formula for FCF.
Where a CPA Firm Meets the Number
No statement a firm closes produces this figure. Every input is read off something else that was closed first: EBIT off the income statement, depreciation off the fixed asset roll-forward, capital expenditure off the investing section, the working capital movement off two balance sheets. Assembling it is a reporting exercise sitting on top of the close rather than a step inside it, and each of those inputs is a classification call made during the close, so the classification risk described in the formula for FCF reaches this measure too.
Two things bite on private clients in particular. The rate applied to EBIT here is an analytical rate rather than the entity’s tax provision, and in an entity whose income is taxed to its owners the entity-level income tax expense is small or absent, a split covered in C corp versus S corp. And whoever asked for the number, a lender, a buyer or the client’s own board, will define it their own way, so the definition has to travel beside the figure.
Common Questions
In ordinary use, yes. Free cash flow to the firm is prior to debt payments and is often referred to as an unlevered cash flow (Aswath Damodaran, NYU Stern, Firm Valuation: Cost of Capital and APV Approaches). Neither name is fixed by any accounting rule, though, so two people can hand you figures under the same label built from different inputs, and the label alone will not tell you they differ.
Start from EBITDA and put the depreciation tax shield back separately: FCFF = EBITDA(1 - Tax rate) + Dep(Tax rate) - FCInv - WCInv, where Dep is depreciation, FCInv is the investment in fixed capital and WCInv the investment in working capital (CFA Institute, Free Cash Flow Valuation). EBITDA is struck before depreciation is deducted, so taxing it denies a deduction the business actually gets, and the second term adds that depreciation tax shield back, landing on the same answer as the EBIT build.
EBITDA = EBIT + depreciation = 900,000 + 140,000 = 1,040,000
EBITDA (1 - tax rate) = 1,040,000 x 0.79 = 821,600
plus depreciation x tax rate = 140,000 x 0.21 = 29,400
851,000
less capital expenditure 631,000
less increase in net working capital 586,000Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a real block of its own close and reporting work through a trial task before a live engagement depends on it.
