Levered Free Cash Flow (LFCF)

Levered Free Cash Flow (LFCF) is an essential concept in finance, especially relevant for investors, analysts, and financial professionals. It represents the amount of cash a company produces after meeting its financial obligations, including interest and debt repayments. It is an insightful measure that helps in assessing a company’s financial health and its ability to generate cash from its business operations after accounting for capital expenditures and debt servicing costs.

Understanding Levered Free Cash Flow (LFCF)

To understand LFCF, it’s crucial first to comprehend Free Cash Flow (FCF). Free Cash Flow, in general, represents the cash generated by a company that is available for distribution among all the company’s security holders. Levered Free Cash Flow, on the other hand, incorporates the effect of debt and interest payments, making it a more accurate reflection of the cash available to equity shareholders.

Formula

The formula to calculate Levered Free Cash Flow is:

LFCF = Net [Income](../i/income.html) + Non-Cash Charges ([Depreciation](../d/depreciation.html) & Amortization) - Change in Working [Capital](../c/capital.html) - [Capital](../c/capital.html) Expenditures - [Debt](../d/debt.html) Repayments

Alternatively, it can also be calculated as:

LFCF = Free [Cash Flow](../c/cash_flow.html) (FCF) - [Interest](../i/interest.html) Payments - Mandatory [Debt](../d/debt.html) Payments

Where:

Net Income is the profit of the company after all expenses, taxes, and costs.
Non-Cash Charges include depreciation and amortization expenses, which impact net income but do not involve actual cash outflows.
Change in Working Capital considers the variations in the company’s current assets and current liabilities.
Capital Expenditures (CapEx) are the funds used by the company to acquire, upgrade, and maintain physical assets such as property, buildings, or equipment.
Interest Payments are the costs incurred by the company for borrowing funds.
Debt Repayments are the principal amount of debt repaid during the period.

Analysis

Analyzing LFCF provides insight into several critical factors of a company’s financial health:

Debt Servicing Ability: LFCF indicates how well a company can service its debt using the cash it generates from its core operations. A positive LFCF means the company can cover its debt obligations while a negative LFCF might indicate potential liquidity issues.
Equity Value: For equity investors, LFCF is an indicator of the cash truly available to them after all debt-related costs have been settled.
Capital Allocation and Efficiency: LFCF reflects the efficiency of a company’s capital allocation strategies. Efficient capital expenditure planning and optimal working capital management contribute to higher LFCF.
Investment Decisions: Investors and analysts use LFCF to decide on potential investments in the company. Positive and stable LFCF trends are considered favorable.

Comparison with Unlevered Free Cash Flow (UFCF)

While Levered Free Cash Flow accounts for interest and principal repayments, Unlevered Free Cash Flow (UFCF) measures the cash flow to the firm before taking into account any debt-related expenses. UFCF represents the cash available to both debt and equity holders and is used in enterprise valuation models.

Formula for UFCF

UFCF = EBIT (1 - [Tax Rate](../t/tax_rate.html)) + Non-Cash Charges - Change in Working [Capital](../c/capital.html) - CapEx

Where:

EBIT is Earnings Before Interest and Taxes.

The distinction between LFCF and UFCF lies chiefly in their treatment of debt and interest payments, making UFCF relevant for all stakeholders, while LFCF is more specific to equity holders.

Levered Free Cash Flow in Financial Modelling

In financial modelling, LFCF is an integral part of cash flow analysis. Analysts construct detailed financial models to forecast a company’s financial performance and derive an estimate of its intrinsic value.

Steps to Model LFCF

Revenue Projections: Estimate future revenues based on historical performance, market trends, and company-specific factors.
Expense Estimations: Predict future operating expenses, including Cost of Goods Sold (COGS), Selling, General, and Administrative (SG&A) expenses.
Non-Cash Adjustments: Adjust for non-cash charges like depreciation and amortization.
Working Capital Forecasts: Project changes in working capital.
Capital Expenditures: Estimate future capital expenditure requirements.
Debt Servicing: Include schedules for interest and principal repayments.

By projecting these components forward, a comprehensive view of LFCF over the forecast period can be achieved.

Importance in Valuation

Levered Free Cash Flow is pivotal in valuation, particularly in equity valuation models like the Levered Discounted Cash Flow (LDCF) model. The LDCF model discounts future LFCF at the cost of equity to arrive at the present value of equity.

Real-World Applications and Examples

LFCF is used extensively in various financial analyses and reports, from corporate financial planning to investment research.

Example in Practice

For instance, consider a hypothetical company, XYZ Corp, with the following annual financial details:

Net Income: $100 million
Depreciation & Amortization: $20 million
Change in Working Capital: -$5 million
CapEx: $30 million
Interest Payments: $10 million
Debt Repayments: $15 million

Using the LFCF formula:

LFCF = 100 + 20 - (-5) - 30 - 15 LFCF = 80 million

This indicates that XYZ Corp has $80 million in levered free cash flow available after meeting its financial obligations.

Conclusion

Levered Free Cash Flow is a robust financial metric that provides deep insights into a company’s real cash-generating capability after accounting for debt obligations. By understanding and analyzing LFCF, stakeholders can make informed decisions regarding investment, financial health assessment, and strategic planning. Whether used in isolation or in conjunction with other financial metrics, LFCF offers vital information that contributes to a holistic view of a company’s financial performance and potential.