How Loans Can Boost Levered Free Cash Flow

Levered free cash flow (LFCF) is a crucial metric for investors and analysts to assess a company's financial health and growth potential. It represents the cash remaining after a company has met its financial obligations, including interest and principal payments. LFCF provides insights into a company's profitability, ability to generate additional revenues, and manage capital expenditures. A company's LFCF can be negative, indicating that its expenses exceed its earnings, which may be temporary and acceptable if the company can secure the necessary cash to survive until its cash flow increases. Taking a loan can impact LFCF by increasing financial obligations and potentially affecting the company's ability to service its debt. Therefore, it is essential to understand the dynamics between levered free cash flow and loan obligations to make informed decisions about a company's financial future.

Levered Free Cash Flow (LFCF) vs. Unlevered Free Cash Flow (UFCF)

Levered Free Cash Flow (LFCF) and Unlevered Free Cash Flow (UFCF) are two methods for analysing a company's free cash flow, each representing a different stage in a company's financial profile.

Unlevered Free Cash Flow (UFCF)

UFCF is the amount of cash a company has before making its debt payments. It is the cash flow before interest payments are taken into account. It is the gross free cash flow generated by a company and is available to pay all stakeholders in a firm, including debt holders and equity holders. It is calculated as Earnings before interest, taxes, depreciation, and amortization (EBITDA) minus capital expenditures (CAPEX).

Levered Free Cash Flow (LFCF)

LFCF is the amount of cash a company has after paying its debts and other obligations. It is the money left over after all a company's bills are paid. It is the cash flow available to pay shareholders. It is calculated as EBITDA minus change in net working capital minus CAPEX minus debt repayments.

LFCF vs. UFCF

LFCF and UFCF are similar, but UFCF represents the total cash a company has available before accounting for any debt payments. In contrast, LFCF deducts payments and debts from the total amount. LFCF is considered the more important figure for investors to watch as it is a better indicator of a company's profitability. However, both LFCF and UFCF can give finance leaders insight into their profitability and organisational health, supporting long-term strategic decision-making.

LFCF calculation

Levered Free Cash Flow (LFCF) is the amount of money a company has left after paying all its financial obligations, including interest on debt. It is calculated using the following formula:

LFCF = EBITDA – Change in Net Working Capital – Capital Expenditures (CapEx) – Debt Repayments (D)

Where:

• EBITDA = Earnings before interest, taxes, depreciation, and amortization
• ΔNWC = Change in net working capital
• CapEx = Capital expenditures
• D = Mandatory debt payments

LFCF is a crucial metric for investors as it provides a holistic view of a company's financial health and profitability. It indicates the amount of cash a company can use to pay dividends or reinvest in its business. A company with a positive LFCF can meet its financial obligations and may have additional cash for expansion or other strategic initiatives.

On the other hand, a negative LFCF indicates that a company's expenses exceed its earnings. While this situation is not ideal, it may be acceptable if temporary, as long as the company can secure the necessary cash to survive until its cash flow increases.

LFCF as a profitability indicator

Levered Free Cash Flow (LFCF) is a profitability indicator for a company. It is the amount of cash that a company has left after paying all its financial obligations, including interest on debt. LFCF is a crucial figure in a company's accounting books as it indicates that money is invested in the right place. LFCF is the amount retained or distributed among stakeholders as dividends after clearing capital expenditure and mandatory debts.

LFCF is considered a better profitability indicator than Unlevered Free Cash Flow (UFCF) because it considers debt payments, providing a more accurate picture of a company's financial health. LFCF is the money left over after all a company's bills are paid, whereas UFCF is the cash flow before debt payments are made. LFCF is the cash flow available to pay shareholders, while UFCF is the money available to pay shareholders and debtholders.

LFCF is important because it is the amount of cash that a company can use to pay dividends and make investments in the business. It measures the ability of a company to expand its business and to pay returns to shareholders (dividends or buybacks) via the money generated through operations. It may also indicate the ability of a company to obtain additional capital through financing.

LFCF need not always be positive since it accounts for the deduction of capital expenditure. Capital expenditure can be a significant sum, but it pays off in the long run. A company with a negative LFCF may not be alarming if it results from strategic investments for future growth, but companies should ensure they can sustain operations until LFCF turns positive.

LFCF as a financial health indicator

Levered Free Cash Flow (LFCF) is a crucial indicator of a company's financial health. It is the amount of money a company has left after meeting all its financial obligations, including interest payments on debt. In other words, it is the cash that remains after a company has paid its bills and serviced its debt. LFCF is important because it indicates how much money a company can use to pay dividends to shareholders or reinvest in the business. A positive LFCF indicates a company's ability to pay dividends, reinvest, and grow, making it attractive to investors. On the other hand, negative LFCF may not be alarming if it results from strategic investments for future growth, as long as the company can sustain operations until LFCF turns positive.

LFCF is considered a more important metric for investors than Unlevered Free Cash Flow (UFCF) because it takes into account debt payments, providing a more accurate picture of a company's profitability. UFCF is the cash flow before debt payments are made and is available to pay all debt holders and equity holders of a firm. While UFCF can provide insight into a company's operations, it does not provide a comprehensive view of its financial health because it does not consider debt and other obligations.

LFCF is a critical indicator of a company's ability to manage its debt and generate cash for its stakeholders. A strong LFCF suggests that a company can comfortably handle its debt payments and still have cash left for other purposes. It is also an essential metric in assessing the potential returns on investment. From the perspective of debt holders and equity investors, LFCF is crucial because it shows how much cash is available to cover debt payments and potentially distribute dividends.

A consistent and growing LFCF can indicate long-term financial health and operational success. It is a valuable tool for investors and analysts to assess a company's financial health and make informed investment decisions. LFCF helps investors evaluate whether a company is a worthwhile investment by providing insight into potential returns.

Risks of LFCF

Levered Free Cash Flow (LFCF) is the amount of money a company has left after paying all its financial obligations, including interest on debt. It is the cash available to stakeholders and equity holders after a company has covered its operating costs, reinvestments, and debt obligations. LFCF is important because it is the amount of cash that a company can use to pay dividends and make investments in the business.

While LFCF is an important metric for investors to examine, there are several risks associated with it:

• Negative LFCF: A company can have a negative LFCF if its expenses exceed its earnings. This situation is not ideal, but as long as it is temporary, investors need not be overly concerned. A company with a negative LFCF must ensure it can secure enough cash to survive until its cash flow increases.
• Difficulty in Raising Capital: A company with excessive existing debt on its balance sheet may struggle to raise additional capital through debt. This is because there may not be enough LFCF to pay back additional debt.
• Perceived Risk by Investors: If a company has a negative LFCF, equity investors may perceive the company as risky, making it challenging to raise funds through equity.
• Limited Financial Flexibility: A company with a low LFCF may have limited financial flexibility. It may find it challenging to obtain additional capital through financing, as it may not have a sufficient cash cushion after meeting its obligations.
• Impact on Growth: A negative LFCF can hinder a company's ability to reinvest in its business and grow. If a company cannot secure additional funding, it may struggle to expand and compete in the market.
• Dividend Payments: A negative or low LFCF may impact a company's ability to pay dividends to shareholders. This could negatively affect shareholder confidence and the company's ability to attract investors.

Frequently asked questions