Unlevered free cash flow measures cash before financing costs

Unlevered free cash flow, or UFCF, measures cash generated by a company’s recurring core operations before interest and other financing payments. It is cash available to all capital providers, including lenders and equity holders, after operating taxes, reinvestment in working capital and capital expenditure.

That makes UFCF useful for comparing operations across businesses with different debt structures. It is also called free cash flow to the firm, or FCFF, and is commonly projected in a discounted-cash-flow, or DCF, valuation of enterprise value.

What unlevered free cash flow includes

“Unlevered” does not mean that tax is ignored. In common valuation practice, the calculation applies tax to operating profit as though the business had no interest expense. This isolates operating performance from the choice of debt and equity financing.

A standard bridge is:

UFCF = EBIT × (1 − tax rate) + depreciation and amortisation − increase in net working capital − capital expenditures

Some models also adjust for recurring items that affect cash flow, such as deferred income taxes. The central principle is consistency: include recurring cash effects of the core business that are relevant to all providers of capital, and exclude financing-specific or non-core items.

• EBIT, or earnings before interest and taxes, is operating profit. Applying the tax rate produces NOPAT, net operating profit after taxes.
• Depreciation and amortisation are added back because they are non-cash expenses in the period, even though they reduce reported operating profit.
• Net working capital captures operating cash tied up in items such as inventory and customer receivables, net of operating liabilities such as supplier payables. An increase consumes cash, so it reduces UFCF. A decrease releases cash, so it increases UFCF.
• Capital expenditure, or CapEx, is spending on long-lived assets such as equipment, buildings and machinery. It is subtracted because it is cash reinvested in the operating asset base.

A worked unlevered free cash flow calculation

Consider a hypothetical manufacturer with the following annual inputs. The figures are illustrative and shown in millions.

• EBIT: $100
• Operating tax rate: 25%
• Depreciation and amortisation: $20
• Increase in net working capital: $15
• Capital expenditures: $30

First calculate NOPAT: $100 × (1 − 0.25) = $75.

Then calculate UFCF: $75 + $20 − $15 − $30 = $50.

The company therefore generated $50 million of cash from operations after tax and reinvestment, before interest payments, debt repayment, dividends or share repurchases. If working capital had fallen by $15 million rather than risen, that line would add $15 million, producing UFCF of $80 million. The working-capital sign convention is a frequent source of errors.

Items normally left out

Net interest expense is excluded because it belongs to the financing decision and relates to lenders rather than the whole capital structure. Preferred dividends and cash-flow-statement financing activities are likewise normally outside UFCF. Common valuation methodologies also exclude non-core other income or expense and many non-recurring gains, losses and non-cash adjustments.

The exact treatment of a particular line item can require judgement. The test is whether it is a recurring cash consequence of core operations and is relevant to all capital providers. A model should document its treatment and apply it consistently across historical periods and forecasts.

UFCF and levered free cash flow

• Unlevered free cash flow: cash before interest and other financing obligations, available to debt and equity providers.
• Levered free cash flow: cash after financial obligations, including interest.

A business can generate strong UFCF while carrying debt obligations that constrain cash available to shareholders or raise refinancing risk. UFCF is therefore not a standalone verdict on financial health; the debt burden and required payments still need separate analysis.

Why UFCF is paired with enterprise value in a DCF

A DCF model forecasts UFCF for an explicit period, discounts those projected cash flows to present value, and estimates a terminal value for cash flows beyond the forecast period. Adding the present values produces an implied enterprise value, the value of the core operating business to all capital providers.

This pairing follows the claimholders represented by each measure: UFCF belongs to the firm’s debt and equity providers, so it is matched with enterprise value. Removing the effects of different borrowing choices can also make operating comparisons more consistent across companies.

Do not assume reported “free cash flow” is UFCF

Free cash flow is not a standardised label in company disclosures. Research published in the Journal of Financial Reporting found that companies use a range of definitions, with almost none matching the theoretical finance definition. The most common definition in the study was operating cash flow less gross capital expenditures.

A reported free-cash-flow measure may not match a valuation-style UFCF calculation. Before comparing figures or inserting them into a valuation model, check the company’s reconciliation and definition, then rebuild the calculation from operating inputs where needed.

Frequently asked questions

What is the difference between unlevered and levered free cash flow?

Unlevered free cash flow excludes interest and other financing obligations, so it represents cash available to debt and equity providers. Levered free cash flow incorporates financial obligations and reflects cash remaining after debt-related claims.

Why is unlevered free cash flow used in a DCF?

A DCF can forecast UFCF, discount the forecast cash flows and terminal value to present value, and derive implied enterprise value. UFCF and enterprise value both relate to all capital providers.

Why can reported free cash flow differ from UFCF?

Companies use differing definitions of reported free cash flow, and the measure is not standardised. Academic research found that the most common disclosed definition was operating cash flow minus gross capital expenditures, which need not match a valuation-style UFCF calculation.

Sources

• What Is Unlevered Free Cash Flow (UFCF)? Definition and ... — www.investopedia.com
• Unlevered Free Cash Flow: How to Calculate & Importance ... — www.allianz-trade.com
• Unlevered Free Cash Flow: Formulas, Calculations, and ... — breakingintowallstreet.com
• Free Cash Flow Disclosure in Earnings Announcements — publications.aaahq.org