Accountants, investors, and business owners who want to understand a company’s profitability should know how to use a levered free cash flow formula (LFCF formula). This article explains what levered free cash flow is and how to calculate it, what factors affect levered free cash flow, and how you can apply it to benefit your business.
What Is Levered Free Cash Flow?
Simply put, levered free cash flow is the amount of money a business has left over after it pays all its bills. The word leverage in the business world refers to debt used to increase revenue. Levered free cash flow can help demonstrate a company’s ability to expand and pay shareholders.
Understanding levered free cash flow is crucial for making informed financial decisions for your company, as it indicates your business’s profitability and its likelihood of obtaining financing (getting funds from investors to support business activities).
Levered Free Cash Flow Formula – Explained
You can use the LFCF formula to calculate levered free cash flow. The LFCF formula can help you determine the overall financial health of your business.
There are a few things you need to know to calculate the LFCF formula.
- What your earnings were before:
- Interest (the percentage charged for borrowing money)
- Depreciation (the cost of a physical asset over its useful life)
- Amortization (the change in value of intangible assets over time)
This amount is called your EBITDA. Your EBITDA helps give you an idea of your company’s value as a whole.
2. Your mandatory debt payments: Everything your company owes to its debtors.
3. Your working capital: The difference between your company’s assets and liabilities.
4. Your capital expenditures: The money used to purchase, maintain, and develop your business’s physical assets, such as buildings and equipment.
The levered free cash flow formula is:
EBITDA – Mandatory Debt Payments – Change in Net Working Capital – Capital Expenditures
Essentially, you take the amount of money you earn before making interest or tax payments or factoring in depreciation or amortization, and then subtract any bills you owe, any changes to the difference between your assets and liabilities, and the money you use to buy assets like property or equipment.
What happens if your LFCF calculations result in a negative amount? Then you have what is called a negative levered free cash flow. While it may sound scary, it’s not necessarily a bad thing. Let’s take a deeper look at what a negative levered free cash flow can mean.
What Does A Negative Levered Free Cash Flow Mean?
There are several different kinds of free cash flow, including:
- Levered free cash flow: The amount of money your business has after its debts are paid
- Unlevered free cash flow: The amount of money your business has before its debts are paid
- Operating free cash flow: Cash flow that results from your business’s main operating activities
- Negative levered free cash flow: When your business’s expenses are more than its income
If your business spends more than it earns, you will have negative levered free cash flow. While negative levered free cash flow can indicate that your company may be considered a high-risk investment, it does not necessarily mean your business is doomed!
For example, maybe you used operating cash flow to purchase new brick-and-mortar storefronts to sell merchandise. These investments could generate major revenue for your company in the future but may result in negative levered free cash flow while you wait for them to turn a profit.
As long as your company has enough money to stay afloat until your revenue increases, having negative levered free cash flow for a limited period will not necessarily hurt your business.
Levered Free Cash Flow Vs. Unlevered Free Cash Flow
While levered free cash flow and unlevered free cash flow are both the net of capital expenditures and working capital, there is one critical distinction between the two.
The difference between unlevered and levered free cash flow is that unlevered free cash flow is the amount of money a company has before it pays its debts, while levered free cash flow is the amount of money a company has after it pays its bills.
Unlevered free cash flow is how much money is available to pay all of your company’s stakeholders, including debt holders (the owners of financial obligations to another party) and equity holders (shareholders and anyone else who owns part of a business). It represents your business’s gross free cash flow.
When it comes to unlevered vs. levered free cash flow, you should understand that the monetary difference between the two can help paint a picture describing your company’s debt level. Investors tend to want to look at your levered free cash flow as it more accurately indicates the risk level involved with financing your company.
What is levered DCF vs. unlevered DCF?
DCF stands for discounted cash flow, a technique for determining a company’s value by projecting future cash flows. DCF relies on the Net Present Value (NPV) method, which calculates future cash flows in current dollar amounts.
A levered DCF projects cash flows after accounting for debt and cash amounts, while an unlevered DCF projects cash flows before debt and cash amounts are applied. A levered DCF values your company’s equity (the money available after selling its assets and paying its debts). An unlevered DCF appraises the value of your company in its entirety.