Valuation
How do you increase business value before an exit?
Someone has asked what you would fix if you had more time. Here is the short list buyers weigh, how to start on each item, and where a second view helps.
Levered vs unlevered free cash flow: what's the difference?
A valuation shows unlevered free cash flow, and the number is bigger than anything you've seen in the bank. Here is what each measure counts, how to calculate it, and which one answers your question.
By Surfside Capital AdvisorsPublished Updated 5 min read
Unlevered free cash flow is the cash a business generates after taxes and reinvestment but before any payment to lenders, so it belongs to lenders and owners together. Levered free cash flow is what remains for the owners after interest, debt repaid, and new borrowing. A cash flow valuation of the whole business starts from the unlevered figure.
A buyer's first model, or a valuation you asked for, shows a line called unlevered free cash flow, and it is larger than anything you have seen land in your bank account. Both can be right. The difference is the debt, and which number matters depends on whose cash you are counting.
What is free cash flow?
Free cash flow is the cash a business produces from its operations after the capital spending it needs. The SEC describes the common version as cash flows from operating activities less capital expenditures, and notes that "this measure does not have a uniform definition and its title does not describe how it is calculated." Whenever you see the term, ask for the formula.
The levered and unlevered versions answer two different questions. Unlevered free cash flow asks what the business produces for everyone who financed it. Levered free cash flow asks what is left for the owners.
How do you calculate unlevered free cash flow?
Start from operating profit, taxed as if the business had no debt, then subtract what the business reinvests. Aswath Damodaran of NYU's Stern School of Business calls it free cash flow to the firm and defines it this way:
Unlevered free cash flow = EBIT × (1 − tax rate) − (capital expenditures − depreciation) − change in non-cash working capital
EBIT is earnings before interest and taxes, your operating profit. Because the tax is worked out before interest, the figure stays the same whether the business carries debt or not. The working capital line is the cash tied up in receivables and inventory, net of what you owe suppliers, and how to calculate the change in net working capital walks through it.
How do you calculate levered free cash flow?
Start from net income, which already has interest and taxes taken out, subtract the same reinvestment, and then account for the debt itself. Damodaran calls it free cash flow to equity:
Levered free cash flow = net income − (capital expenditures − depreciation) − change in non-cash working capital − (principal repaid − new debt issued)
Because the term has no uniform definition, a model may stop after interest and leave principal out. Check which version you are looking at before you compare two figures.
Levered vs unlevered free cash flow: how do they compare on one business?
The gap between them is the after-tax cost of the debt plus the principal paid down. The figures below are an illustration, with a flat 25% tax rate.
| Line | Unlevered | Levered |
|---|---|---|
| EBIT (operating profit) | $1,200,000 | $1,200,000 |
| Interest | not deducted | −$200,000 |
| Income tax at 25% | −$300,000 | −$250,000 |
| After-tax profit | $900,000 | $750,000 |
| Capital expenditures minus depreciation ($250,000 − $150,000) | −$100,000 | −$100,000 |
| Increase in non-cash working capital | −$80,000 | −$80,000 |
| Principal repaid minus new borrowing | not deducted | −$300,000 |
| Free cash flow | $720,000 | $270,000 |
The business produces $720,000 for everyone who financed it. After the lender is paid, $270,000 is left for the owners. The $450,000 gap is the $150,000 of interest after tax plus the $300,000 of principal.
A business with no debt and no non-operating income shows the same number for both measures.
Which one matters when you sell the business or take on debt?
Unlevered free cash flow values the whole business, and levered free cash flow values the owners' share. In Damodaran's survey of valuation methods, cash flows before debt payments are discounted at the cost of capital, the blended cost of all the financing, to value the firm. Cash flows after debt payments are discounted at the cost of equity to value the equity alone.
Done right, the two routes reach the same value for the equity, because the value of the whole business minus the debt and other claims ahead of the owners is what the owners hold. So in a valuation built on unlevered free cash flow, the debt you carry comes out of the value of the business before anyone reaches the owners' share, as how much should I sell my business for explains from the seller's side.
Levered free cash flow answers your own question: what the business can pay its owners after it meets its debt payments. If it is thin or negative while unlevered free cash flow is healthy, the business is profitable and the debt schedule is taking the cash. That is the moment to look at the terms of the debt, as debt restructuring vs refinancing covers.
What to do next
- Calculate both measures for each of your last three years from your financial statements, using the formulas above.
- Check levered free cash flow against what you actually distributed and what stayed in the bank, so you trust the inputs.
- When anyone shows you either figure, ask for the formula, the tax rate, and the period it covers.
- Forecast both for the next 12 to 24 months, so you can see when debt payments will squeeze what is left for the owners.
We build the cash flow forecast and the valuation model with you, so you see both figures before you sit down with a buyer or a lender. That is part of our cash flow and M&A advisory work.
Questions owners ask
Is free cash flow the same as EBITDA?
No. EBITDA (earnings before interest, taxes, depreciation, and amortization) leaves out taxes, capital spending, and changes in working capital, and unlevered free cash flow subtracts all three. A business that needs a lot of equipment can show strong EBITDA and thin free cash flow. How to calculate an EBITDA multiple covers the multiple applied to EBITDA.
Which tax rate goes into unlevered free cash flow for an S corporation?
An S corporation generally passes its income through to its shareholders, who pay the federal income tax on their own returns (IRS). A model may still apply a tax rate, to put the business on the same footing as a corporation that pays tax, or it may apply none. Ask which it uses, because the choice changes the figure and any value built on it.
General information, not legal, tax, or investment advice.
Sources
- Non-GAAP Financial Measures, Compliance and Disclosure Interpretations, Question 102.07, U.S. Securities and Exchange Commission, Division of Corporation Finance,
- Variable definitions (free cash flow to firm, free cash flow to equity), Aswath Damodaran, Stern School of Business, New York University,
- Valuation Approaches and Metrics: A Survey of the Theory and Evidence, Aswath Damodaran, Stern School of Business, New York University,
- S corporations, Internal Revenue Service,
Figures and rules as published by these sources on the dates shown.
Free consultation
Facing this decision now?
Talk it through with our team in a free 30-minute consultation, in English or Spanish, with no obligation.
Newsletter
The numbers behind your next decision, in your inbox.
From the finance team at Surfside Capital Advisors, for owners and leadership teams: cash, planning, deals, and what to look at before a raise or a sale.
Keep reading
Valuation
Why growing revenue can still lower business value
Sales are up, and the number a buyer mentions has not moved. Here is how four kinds of growth can lower value, and how to rebuild your earnings the way a buyer will.
Valuation
How do you calculate the change in net working capital?
A letter of intent mentions a normal level of working capital, or your sales grow while your cash shrinks. Here is the calculation, what it tells you, and how it reaches a sale price.