What is Levered Free Cash Flow?
Levered Free Cash Flow (LFCF) is the residual cash belonging to only equity holders after deducting operating costs, reinvestments (e.g. working capital and capital expenditures), and financial obligations.
How to Calculate Levered Free Cash Flow (Step-by-Step)
Levered free cash flow, or “free cash flow to equity”, represents a company’s remaining cash flows generated from its core operations once all spending obligations related to operating costs, reinvestments, and debt-related payments are fulfilled.
- Operating Costs: Cost of Goods Sold (COGS) and Operating Expenses (SG&A, R&D)
- Reinvestments: Net Working Capital (NWC), Capital Expenditure (Capex)
- Financial Obligations (Debt-Related): Mandatory Debt Amortization, Interest Expense
Once the items listed above are deducted, the leftover cash flow belongs to the shareholders of the company, i.e. those in possession of shares that represent partial ownership stakes in the company’s equity.
While the remaining proceeds technically belong to the shareholders, the allocation of the cash is at management’s discretion.
- Dividend Issuance: Cash Payments to Preferred and Common Equity Shareholders
- Reinvestment: Reinvest the Funds into Operations (Working Capital, Capex)
- Stock Buyback: Repurchase Previously Issued Shares to Reduce the Number of Shares in Circulation
Thus, equity shareholders such as private equity firms pay close attention to the levered free cash flow metric, since LFCF can be a proxy for the state of a company’s financial health.
- Higher LFCF: More Discretionary Cash, Greater Debt Capacity, and Low Credit Risk
- Low LFCF: Less Discretionary Cash and Less Debt Capacity, and High Credit Risk
Levered Free Cash Flow vs. Unlevered Free Cash Flow
- Levered Free Cash Flow: LFCF is a “levered” measure of cash flow because of the inclusion of expenses that stem from financing obligations, namely interest expense and mandatory debt repayment. For instance, interest payments are received only by debt holders, which are higher in priorty than all equity holders in the capital structure. Since LFCF pertains only to equity shareholders, the discount rate it pairs with is the cost of equity (ke), which would be used to calculate the equity value in a levered DCF model. The levered DCF is seldom used in practice, aside from for financial institutions, as the core of their business model is oriented around lending (and earning interest income).
- Unlevered Free Cash Flow: On the other hand, UFCF is an “unlevered” measure of cash flow since the spending obligations deducted are applicable to all capital providers, i.e. both debt lenders and equity holders. Instead of starting from net income – which is post-interest and includes the tax savings from the interest tax shield – the calculation of UFCF starts from a capital-structure neutral metric, NOPAT, and does not account for any repayment of debt obligations. Because UFCF represents all stakeholders, rather than only one capital provider group, the corresponding discount rate is the weighted average cost of capital (WACC), which calculates the enterprise value (TEV) in an unlevered DCF model.