Levered free cash flow is the amount of money a company retains after meeting all its financial obligations. These obligations also include debts instead of the unlevered free cash flow, which considers cash before paying off debt.
This measure is useful for analysing a company’s ability to generate cash flow to service its debt obligations and distribute cash to its investors.
Continue reading to understand the definition of levered free cash flow, its formula, and calculations.
Levered Free Cash Flow — Definition
In finance, levered typically refers to using debt to finance a company’s operations or investments.
When a company uses debt financing, it increases its leverage, which means it has taken on more risk because it has to make interest payments on the debt and repay the principal. This is in contrast to unlevered or unleveraged companies, which do not have any debt or have very little debt on their balance sheet.
In the context of free cash flow, levered free cash flow (LFCF) is the cash a company generates through its operations. LCF (levered cash flow) measures the cash flow available to equity holders after making debt payments. It measures a company’s capacity to expand its business while paying returns to shareholders.
It also indicates a company’s ability to raise capital financing. This is because if debt obligations weigh the company down, raising capital from a lender may be difficult. However, a healthy LFCF makes a company relatively risk-free and becomes an attractive option for investors and lenders.
Levered Free Cash Flow — How to Calculate?
The levered free cash flow formula is represented by the following equation:
LFCF = EBITDA - ΔNWC - CapEx - D
In this equation:
EBITDA = earnings before interest, tax, depreciation, and amortisation (a measure of a company's profitability that looks at its earnings before certain expenses are deducted.)
ΔNWC= net change in working capital (the difference between a business's current assets and its current liabilities.)
CapEx = Capital expenditures (the money a company spends on buying or improving its fixed assets, such as buildings or equipment.)
D = compulsory debt payments (the payments a company is required to make on its outstanding debt.)
The levered free cash flow can be negative or positive. However, a negative value does not indicate that a company is failing. The company could have had more substantial capital investments yet to pay off. A temporary negative value is acceptable if it can secure the cash necessary to survive.
Levered Free Cash Flow Yield
A levered free cash flow yield is the ratio of your levered cash flow to your market capitalisation. It represents the cash return on investment an investor can expect from a company's levered free cash flow.
The levered free cash flow yield is a useful metric for evaluating the relative value of different companies, as it considers both their cash generation and market valuation.
What is the difference between Free Cash Flow and Levered Free Cash Flow?
Free cash flow (FCF) refers to the amount of cash left after a company has fulfilled its operating and capital expenditures. It is the cash available for distribution to its investors, including shareholders and debt holders.
On the contrary, LFCF shows the amount left over for shareholders after all obligations have been made, including debt, operational, and capital expenditures.
The major differences between free cash flow and levered free cash flow are given in the following table:
|Basis||Free Cash Flow (FCF)||Levered Free Cash Flow (LFCF)|
|Calculation||Operating cash flow – capital expenditures||FCF – mandatory debt payments|
|Focus||Cash that is available to all investors||Cash that is available to equity investors|
|Debt||Excludes debt considerations||Includes debt considerations|
|Purpose||Evaluating a company's financial health and ability to invest or pay dividends||Used to value a company and determine equity value|
|Significance of Debt||Does not reflect the impact of debt on a company's cash flow||Reflects the impact of debt on a company's cash flow
Levered Free Cash Flow — Example
Here's an example of how to calculate levered free cash flow for a hypothetical company. Assume the following financial information for the company:
- Operating cash flow: £100 million
- Capital expenditures: £50 million
- Mandatory debt payments: £10 million
To calculate LFCF, we would subtract the mandatory debt payments from the Free Cash Flow (FCF) as follows:
The formula of FCF is as follows:
FCF = Operating cash flow - Capital expenditures
FCF = £100 million - £50 million
FCF = £50 million
This means LFCF would be:
LFCF = FCF - Mandatory debt payments = £50 million - £10 million = £40 million
Therefore, the LFCF for this company is £40 million. This means that after accounting for both capital expenditures and mandatory debt payments, the company has £40 million of cash available to distribute to its equity investors.
Levered free cash flow plays a crucial role in assessing a company's capability to generate cash flow to meet its debt obligations and distribute cash to investors. Additionally, it reveals a company's potential to acquire capital financing, and a strong LFCF enhances a company's appeal to investors and lenders by reducing its risk.
Unlike free cash flow, which indicates the remaining cash after meeting operating and capital expenditures, LFCF factors in debt payments, capital expenditures, and operational expenses, revealing the leftover amount for equity investors.
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