Levered free cash flow (LFCF) plays a pivotal role in a company’s financial landscape. This article provides a comprehensive understanding of LFCF, its calculation, significance, and how it differs from unlevered free cash flow (UFCF). Explore the pros and cons, FAQs, and key takeaways to harness the full potential of LFCF for your business.
Understanding levered free cash flow (LFCF)
Levered free cash flow (LFCF) is a financial metric that showcases a company’s financial strength by revealing the surplus cash remaining after settling all its financial obligations. This metric is a critical component of a company’s financial strategy, as it provides a clear picture of the cash available for various purposes, including dividend payouts, stock buybacks, or reinvestment in the business.
Formula and calculation of levered free cash flow
LFCF can be calculated using the following formula:
LFCF = Earnings before interest, taxes, depreciation, and amortization (EBITDA) – Change in net working capital (ΔNWC) – Capital expenditures (CapEx) – Mandatory debt payments (D)
In this formula:
- EBITDA: Earnings before interest, taxes, depreciation, and amortization
- ΔNWC: Change in net working capital
- CapEx: Capital expenditures
- D: Mandatory debt payments
LFCF reflects a company’s ability to expand its operations and reward shareholders through dividends or stock buybacks. It also serves as an indicator of the company’s potential to secure additional capital through financing.
If a company has a substantial amount of debt and limited cash reserves after meeting its financial obligations, it may face challenges in obtaining additional financing. Conversely, a healthy LFCF makes a company more attractive to investors and less risky for lenders, as it signifies the company’s ability to meet future obligations and invest in growth.
Even if a company reports negative levered free cash flow, it does not necessarily indicate financial distress. Negative LFCF may result from significant capital investments that have yet to generate returns. As long as the company can secure the necessary funding to bridge this gap, a temporary period of negative LFCF can be managed and is often acceptable in pursuit of long-term growth.
How a company chooses to allocate its levered free cash flow is a strategic decision. Companies may opt to use a substantial portion of LFCF for dividend payments or reinvestment in the business. Alternatively, if management identifies significant growth opportunities, they may allocate most of the LFCF to fund expansion and market diversification.
Levered free cash flow (LFCF) vs. unlevered free cash flow (UFCF)
Levered free cash flow (LFCF) and unlevered free cash flow (UFCF) are both vital financial metrics, but they differ in key ways:
LFCF represents the cash available to a company after settling debts and other financial obligations. In contrast, unlevered free cash flow (UFCF) reflects cash availability before debt payments. The calculation for UFCF involves subtracting capital expenditures, working capital changes, and taxes from EBITDA.
LFCF is particularly crucial for investors as it provides a clearer picture of a company’s profitability and financial strength. It signifies the cash flow that can be directed toward shareholders, making it a central figure in investment decisions.
Pros and cons of levered free cash flow (LFCF)
Here is a list of the benefits and drawbacks to consider.
- Provides insight into a company’s financial health
- Guides strategic decisions, such as dividend payouts and investments
- Attracts investors and reduces borrowing risks for the company
- May be negative during periods of heavy investment
- Does not consider the cost of capital
Frequently asked questions
What is the significance of levered free cash flow (LFCF)?
LFCF is essential as it reveals the cash a company has after fulfilling its financial obligations. It influences a company’s ability to pay dividends, invest in growth, and attract investors and lenders.
Can a company have negative levered free cash flow (LFCF) and still be healthy?
Yes, a company with negative LFCF isn’t necessarily in poor health. Negative LFCF may result from substantial capital investments that have yet to generate returns. As long as the company can secure necessary funding during this period, negative LFCF can be manageable.
How does levered free cash flow (LFCF) differ from unlevered free cash flow (UFCF)?
LFCF reflects cash available after settling debts, while UFCF represents cash availability before debt payments. LFCF is considered more important for investors as it offers a clearer picture of a company’s profitability and its ability to reward shareholders.
Is levered free cash flow (LFCF) affected by a company’s debt level?
Yes, LFCF takes into account mandatory debt payments, so a company with high debt levels may have lower LFCF. However, a well-managed company can still maintain a healthy LFCF by effectively balancing debt obligations with cash flow generation and investment decisions.
Can a company with negative levered free cash flow (LFCF) attract investors?
Yes, attracting investors with negative LFCF is possible if the company can present a compelling growth story and demonstrate a clear path to positive cash flow in the future. Investors may be willing to support companies with negative LFCF if they believe in the long-term potential and management’s strategic vision.
- Levered free cash flow (LFCF) is the surplus cash a company has after paying its financial obligations.
- A positive LFCF indicates a company’s ability to pay dividends, invest in growth, and attract investors.
- Negative LFCF may be due to substantial capital investments that have yet to yield returns and can be manageable with proper funding.
- LFCF is distinct from unlevered free cash flow (UFCF), with LFCF considered more important for investors.
View Article Sources
- Company Cost of Capital and Leverage: A Simplified Textbook Relationship Revisited – PubMed
- Exhibit 99.2 – Explanation of Non-GAAP and Other Financial Measures – U.S. Securities and Exchange Commission
- Reconciliation of Free Cash Flow to Net Cash Provided by Operating Activities – U.S. Securities and Exchange Commission
- Why Are Investors Paying (More) Attention to Free Cash Flows? – University of Nebraska-Lincoln
- Understanding Cash Flow from Investment Activities – SuperMoney
- Cash Flow Statement: A Beginner’s Guide to Reading and Understanding It – SuperMoney