Free Cash Flow vs. Unlevered Free Cash Flow vs. Levered Free Cash Flow (20:13)
You’ll learn about metrics and multiples based on cash flow in this lesson, and you’ll understand how each of them is subtly different from the others.
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Why Should You Care About Cash Flow-Based Metrics?
Could come up in interviews – VERY common to get asked how you define Unlevered Free Cash Flow, Levered Free Cash Flow, Free Cash Flow…
And you need to know these metrics when valuing companies, especially in the Discounted Cash Flow (DCF) analysis – not AS useful for comparing different companies as metrics such as EBITDA and EBIT are.
Problems with Cash Flow-Based Metrics for Comparison Purposes:
1. They take longer to calculate – more complicated than just Operating Income + D&A, for example – you need the whole CFS!
Plus: information on a company’s tax rate, mandatory debt repayments, etc. etc.
2. They’re more discretionary and vary more by individual company – in this case, for example, different Working Capital requirements create massive differences in cash flow between Steel Dynamics and LinkedIn.
Other issues: Different non-cash adjustments, different CapEx policies (3% of revenue vs. 18% of revenue here!), different ways of preparing the Cash Flow Statement! (Direct vs. indirect vs. starting with EBIT).
Bottom-Line: Cash Flow metrics have their uses, but they are more about approximating a company’s cash flow, for use in other analyses such as the DCF, and they are LESS useful for comparing different companies.
FCF vs. Levered FCF vs. Unlevered FCF — Key Differences
Basic idea is similar with all 3 metrics: “How much discretionary cash flow does this company generate?”
Remember: Items in the Financing section and most items in the Investing section of the Cash Flow Statement are “optional” — the only one that’s really required is CapEx, which represents re-investment in the business.
So UNLIKE metrics such as EBITDA, these cash flow metrics all directly reflect the impact of CapEx, taxes, and working capital.
The Difference: They all treat interest expense and debt repayment differently.
Free Cash Flow: Includes interest expense, but NOT debt issuances or repayments.
Unlevered Free Cash Flow: Excludes interest expense and ALL debt issuances and repayments.
Levered Free Cash Flow: Includes interest expense, and mandatory debt repayments (but opinions on this differ!).
Free Cash Flow: Cash Flow from Operations – CapEx.
Unlevered Free Cash Flow: NOPAT + Non-Cash Adjustments and Changes in Working Capital from CFS – CapEx
Levered Free Cash Flow: Net Income + Non-Cash Adjustments and Changes in Working Capital from CFS – CapEx – (Mandatory?) Debt Repayments
BUT… IFRS and the Direct Method of Cash Flow Statement preparation make these calculations trickier.
Problems: Companies may not always include Taxes and the Interest Expense within the Cash Flow from Operations section — or they might start with EBIT and show these items separately, or scattered across the Cash Flow Statement.
So you need to be REALLY careful about how you run the numbers – we always recommend converting the CFS to the Indirect version, if possible.
Which Metric Do You Use, and Why?
Again, it’s a question with a false premise (as we saw with EBIT vs. EBITDA vs. Net Income).
The issue here is that you could use any of these to create valuation multiples… even Cash Flow from Operations would be OK!
But you rarely do that because of all the issues discussed above – they take too long to calculate, they’re harder to project, and they vary a lot by company and industry.
Better Question: WHEN do you use each metric, in most cases, and why?
Free Cash Flow: Standalone financial statement analysis (e.g., what is a company doing with its discretionary cash flow?).
Unlevered FCF: Very common in discounted cash flow (DCF) analysis.
Levered FCF: Quite rare; can use it in a DCF in some industries, and may also be used to assess a company’s true debt service capabilities.