Free cash flows are commonly used in financial analysis. They are derived by deducting cash outflows from cash inflows. Unlevered free cash flow (UFCF) is the cash flow before deducting the financial obligations. Leverage is another term for debt, which means UFCF does not take debt financing into account. Unlevered free cash flow is available both for debt and equity holders of the company.
The formula to compute UFCF is:
UFCF = EBIT – CAPEX – Net Working Capital – Taxes
Whereas:
EBIT (Earnings before Interest and Tax)
= It is an alternative to net income when assessing the business' financial performance, computed as revenue – costs of goods sold and selling and administrative expenses
CAPEX = This is the investment in fixed assets such as land, building, and machinery & equipment
Working Capital = Current assets (except cash) minus current liabilities
Tax = The owed taxes by the business
Example:
Let's say you have an EBIT of $ 150,000 for the 1st year, CAPEX of $50,000, Net Working Capital (NWC) of $15,000, and taxes owed amounting to $25,000.
UFCF = EBIT– CAPEX – NWC – Taxes
UFCF = $ 150,000 - $ 50,000 - $ 15,000 - $ 25,000
UFCF = $ 60, 000
The $60 000 is the amount you can use for business expansion or distribute to the company's debt holders and equity holders.
Why Use Unlevered Free Cash Flow in Business Valuation?
Unlevered free cash flows are used in financial modeling. Because businesses have different financing structures, excluding the leverage in valuation, levels the playing fields when comparing various companies' performances. It is also easier to evaluate the company's performance compared to the industry average, which allows the business to assess what needs to improve in its operation and expedite the company's upper hand to bring in more sales.
Discounted Cash Flow (DCF) Valuation is a financial planning tool that uses unlevered free cash flow. It utilizes UFCF in the business valuation based on the time value of money using a discount rate (usually Weighted Average Cost of Capital).
On the downside, using the unlevered free cash flow is not always a good representation of the business financial situation, especially for highly leveraged companies. These companies may opt to use UFCF to show the good side of their businesses. Highly-leveraged businesses are prone to financial chaos if finances are not properly managed.
When analyzing a company, utilize the levered cash flows and discounted cash to determine if the company will still be feasible after considering the debt structures and time value of money.
The unlevered free cash flow is indispensable in fundamental financial analysis when valuing a business and comparing it to peer competitors and industry average. Nevertheless, due diligence should be done to ensure the utilization of other cash flows in evaluation.
Financial model templates, which utilize unlevered free cash flows, are widely available online. eFinancialModels has prepared various financial model templates you can utilize to create your financial model to do business valuation and performance measure of your company.
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