Clearing Up the Confusion about Free Cash Flow (FCF), Unlevered Free Cash Flow (UFCF) and Levered Free Cash Flow (LFCF)

Many beginners as me get their mind boggled about technical terms in finance. WACC, Cost of Capital, Discount Rate, Interest Rate, Federal Fund Rate… getting dizzy? If you are still having hard time explaining to yourself which is which, don’t worry, I would like to tell you that you are not alone! Just take it easy, let us study together and share our knowledge.

One of the frequently asked interview questions in finance technical interview is as follows,

If you knew a company’s net income, how would you figure out its free cash flow?

How would you answer this question? (Take 10 seconds to think about it!)

1.Back to Basics

When you open up a firm’s statement of cash flow, you will see there are three streams of cash flows, Cash Flow from Operating Activities (CFO), Cash Flow from Investing Activities (CFI) and Cash Flow from Financing Activities (CFF). A firm’s key operating activities define which type of business model it is in and what industry it operates in. Therefore, majority of the cash flows into the firm from conducting those operating activities. The firm buys assets or invests in projects according to its operating needs using capitals from either equity or debt. These decisions involves financing activities.

2. Definition of “Free”

What is “free” cash flow anyway? The operative word here is free. It is a measure of a firm’s financial comfort level. The higher the free cash flow, the stronger the firm’s balance sheet. In other words, free cash flow is the cash that is available to be distributed in a discretionary way. As you move along in your career, you will know how the importance free cash flow is to corporate managers and shareholders since it’s a crucial measure to define success and improve shareholder value. That is enough for interpreting the operative word in the context.

3. Demystifying the Terms

Now let’s talk about how do we compute free cash flow. Free cash flow is firmly related to the cash from operating activities, so it is computed as follows,

Free Cash Flow (FCF)

= Cash Flow from Operations (CFO) −Capital Expenditure (CapEx)

or more precisely,

= Net Income (NI)+Non −cash Expenses-Increase in Working Capital-Capital Expenditure

where,

Non-cash Expenses include depreciation, amortization, stock-based compensation, impairment charges and either gain or losses on investments.

Working Capital includes accounts receivable, inventory, accounts payable, etc.

In real life, it is not always clear when someone uses the term FCF. You have to be in the context where the term mentioned, because there are several types to the free cash flow. The most common types are Free Cash Flow to the Firm (FCFF), or in a more intuitive way, some folks love to use Unlevered Free Cash Flow (UFCF) and Free Cash Flow to Equity (FCFE). Yes, of course, the financiers gave it another fancy name, Levered Free Cash Flow (LFCF).

In the following steps, let’s talk about FCFE/LFCF and FCFF/UFCF.

As we know equity investors are the last in line to claim, therefore FCFE is the effects of net capital expenditures, changes in working capital, and net changes in debt.

Free cash flow to equity =

• Net income
• Minus: Capital expenditures
• Plus: Depreciation
• Minus: Change in non-cash working capital
• Plus: New debt issued − Debt repayments

FCFF is all the free cash flows to all claim holders, which includes common stockholders, bondholders, and preferred stockholders. There are two ways to calculate FCFF.

Free Cash Flow to Firm or Unlevered Cash Flow =

• Free cash flow to equity, which is cash flow to common stockholders
• Plus: Interest expense(1 − Tax rate) + Principal repayments − New debt issues, which is cash flow to lenders
• Plus: Preferred dividends, which is cash flow to preferred stockholders

If you have noticed, we are actually reversing the process of getting FCFE (by adding back payments to lenders and preferred stockholders to estimate the cash flow left for stockholders), so we can calculate the FCFF in a simpler way as follows:

FCFF = EBIT(1 − Tax rate) + Depreciation − Capital expenditure − Δ Working Capital

4. Bonus

There is another cash flow like measure, which is EBITDA. EBITDA is a proxy for discretionary cash flow available to service debt, pay taxes, fund reinvestment, and provide for owner distributions regard to interest expense. Always remember, the operative word here is “proxy”. EBITDA may give you an eyeballing number, but it does not make sense to use EBITDA in lieu of operating cash flows in a more drilled down financial analysis.