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Unlevered Free Cash Flow (also known as Free Cash Flow to the Firm or FCFF for short) is a theoretical cash flow figure for a business. It is the cash flow available to all equity holders and debtholders after all operating expenses, capital expenditures, and investments in working capital have been made.
Unlevered Free Cash Flow is used in financial modeling to determine the enterprise value of a firm. It is technically the cash flow that equity holders and debt holders would have access to from business operations.
Unlevered Free Cash Flow Formula
The formula is:
Why is Unlevered Free Cash Flow Used?
Unlevered free cash flow is used to remove the impact of capital structure on a firm’s value and to make companies more comparable. Its principal application is in valuation, where a discounted cash flow (DCF) model is built to determine the net present value (NPV) of a business. By using unlevered cash flow, the enterprise value is determined, which can easily be compared to the enterprise value of another business.
Why is Capital Structure Ignored?
There are two main reasons capital structure is ignored when performing a valuation:
It makes firms comparable
Capital structure is somewhat discretionary, and owners/managers could theoretically place a different capital structure of their choosing on the firm
Let’s explore each of these ideas in more detail below.
Comparability. Since some companies have a high interest expense, while others have little to no interest expense, the levered cash flow of two firms can be skewed by the impact of interest. By removing the interest expense and recalculating taxes, it’s much easier to make an apples to apples comparison.
Discretionary. This point is somewhat theoretical, as firms may be limited in how much flexibility they have, but in theory, the owners or managers of the business can put whatever capital structure they want on the business.
How to Calculate Free Cash Flow to the Firm
Here is a step-by-step example of how to calculate unlevered free cash flow (free cash flow to the firm):
Begin with EBIT (Earnings Before Interest and Tax)
Calculate the theoretical taxes the company would have to pay if they didn’t have a tax shield (i.e., without deducting interest expense)
As you can see in the example above and the section highlighted in gold, EBIT of $6,800, less taxes of $1,360 (without deducting interest), plus depreciation and amortization of $400, less an increase in non-cash working capital of $14,000, less capital expenditures of $40,400, results in unlevered free cash flow of -$48,560.
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Arriving at Equity Value
When using unlevered free cash flow to determine the Enterprise Value (EV) of the business, a few simple steps can be taken to arrive at the equity value of the firm.
To arrive at equity value, take the following steps:
Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
A well rounded financial analyst possesses all of the above skills!
Additional Questions & Answers
CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.
In order to become a great financial analyst, here are some more questions and answers for you to discover:
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