Levered Free Cash Flow (LFCF)

Understanding cash flow is critical to analyzing and interpreting the financial position of your company and its ability to continue to operate effectively.

But here’s the thing:

There’s more than one type of cash flow. Or more specifically, there are a number of financial terms we use to delineate different cash flow measurements.

In this article, we’re going to be turning our attention to levered free cash flow, one of two kinds of free cash flow you need to know about to better understand your company’s profitability levels.

What Is Levered Free Cash Flow?

Levered free cash flow is the amount of capital (cash) your business has for a given period after you’ve accounted for all payments to your financial obligations, both short-term and long-term.

This means you take the cash you earned for the period, subtract your cash outflows for things like wages and rent as well as debt repayments and capital investments, and what’s left over is called your levered free cash flow.

This represents money that is available for payouts to investors, management, and shareholders by way of dividends or for future business investments.

It goes by a couple of other names, by the way (levered cash flow, or under the abbreviation LFCF or LCF), so if you hear those terms thrown around, just know that they all mean the same thing.

Levered vs. Unlevered Free Cash Flow

Levered cash flow has a twin brother: unlevered free cash flow.

The simple difference here is that unlevered free cash flow doesn’t consider repayments to financial obligations, such as debt repayments.

It essentially functions as if the company owns all of its capital (and hasn’t secured it through debt or equity financing).

As such, it tends to be the less useful metric for looking at an individual company’s profitability and performance.

The only real use case on an individual basis is that you can compare LFCF with UFCF to determine how leveraged the company is (how many financial obligations it has), though you can typically see this in the big three financial statements anyway.

Where UFCF does have a benefit, however, is when comparing two different businesses side by side, where you’re able to stack up performance without consideration for how the company obtained its capital.

How To Calculate Levered Free Cash Flow

To calculate levered free cash flow, you’re going to need the following figures ready:

• EBITDA (earnings before interest, taxes, depreciation, and amortization): an alternative to net income that finance leaders use to determine general financial performance
• CAPEX (capital expenditures): investments in plant, property, equipment, machinery, equipment, and so on
• Change in working capital: adjustments to the total amount of working capital available
• Mandatory debt payments: repayments to debtors such as lenders, investors, or interest payments

From there, you’re levered free cash flow formula is:

Levered Free Cash Flow = EBITDA – CAPEX – change in net working capital – mandatory debt payments

To really understand how this works in process, it’s helpful to look at an example.

Levered Free Cash Flow Example

Let’s say you run a retail clothing store.

You got into business three years ago, putting down $200,000 of your own money from the sale of a previous venture, and used that capital to secure a loan of $400,000, giving you a total of $600,000 to start the company.

That debt is repayable over three years, with an annual interest rate of 15%, meaning your monthly loan repayments come out at $7,500.

EBITDA has been slowly growing. You made $200,000 in the first year, doubled that in the second year to hit $400,000, and continued growing to $500,000 in your third and most recent year.

Year 1 was pretty heavy on capital expenditures, where you spent $350,000 getting set up. Your second year didn’t require any CAPEX investment, but in Year 3, you spent another $100,000 on updating some equipment and property to fuel further growth.

Working capital across the three years of business looked like this:

• Year 1: $50,000
• Year 2: $100,000
• Year 3: $150,000

When calculating levered free cash flow, we want to start by pulling together the figures we need:

	Year 1	Year 2	Year 3
EBITDA	$200,000	$400,000	$500,000
Mandatory debt payments	$90,000	$90,000	$90,000
CAPEX	$350,000	$0	$100,000
Working Capital	$50,000	$100,000	$150,000

Remember that our LFCF is to take EBITDA and then subtract the remaining three figures:

LFCF = EBITDA – CAPEX – change in net working capital – mandatory debt payments

Here’s what that looks like across our three years:

1. LFCF = $200,000 – $350,000 – $50,000- $90,000 = -$290,000
2. LFCF = $400,000 – $0 – $100,000 – $90,000 = $210,000
3. LFCF = $500,000 – $100,000 – $150,000 – $90,000 = $160,000

The Importance Of The LFCF Metric

So, now that you’ve calculated your levered free cash flow, the question begs:

What does this say about my business? And how do I know if this is a good thing or a bad thing?

The answer lies in the context (which means you need to do a bit of financial analysis).

Levered free cash flow can either be positive or negative, and generally, we want it to be positive. Hell, generally speaking, we want all cash flow to be positive.

But negative LFCF isn’t necessarily a signal that your business is in a bad place: it just means that you spent more on debt repayments and capital expenditure than the amount of cash you brought in.

If, for example, you dig into the levered free cash flow calculation of a given company and discover that its EBITDA is trending downwards, and a lot of this is being paid out to mandatory debt obligations, this might not be a good signal.

You might take this as a sign that the company is overleveraged and struggling to turn that capital into an effective operation that throws off cash.

But what if the opposite is true?

EBITDA is trending upwards, debt repayments aren’t outside of expectation, and the company is in negative levered free cash flow because it is spending all of its cash on capital expenditures.

This can be taken as a sign that the business is investing heavily in future opportunities and using its increased earnings to double down on growth through capital investments.

In short, negative cash flow isn’t always bad.

In fact, the same is true of positive LFCF.

Largely speaking, if LFCF is positive, this is a good sign that the company has a healthy relationship with debt and is generating sufficient cash to invest in CAPEX and still be able to pay returns to shareholders via dividends or buybacks.

But what if it isn’t spending on capital expenses?

This could be a sign that the leadership of the company doesn’t see a long-term horizon for the business or is trying to bolster its numbers and keep shareholders happy by neglecting to reinvest in the business.

In this case, you might consider this a bad sign, even though levered free cash flow is positive.

Of course, in the best of all scenarios, you’re going to see a positive LFCF (hopefully trending upwards over time) coupled with EBITDA growth and sufficient reinvestment in capital expenditure to continue maximizing future expansion opportunities.

If it’s not yet clear what all of this means, what we’re saying is that viewing levered free cash flow in a vacuum, for a single period, isn’t the right way to look at things.

Yes, this can tell you something about the company’s financial health for the period in question, but what you really want to do is dig in and analyze LFCF trends over the long term, as well as the specific metrics that make up levered free cash flow.

Track Levered Free Cash Flow In Finmark

Understanding how to calculate, interpret, and analyze levered free cash flow is an important step in improving the financial performance of your company and creating strategies for future growth.

That last part (the analysis and strategizing) is where the value really is, though.

Save yourself all the time and headache pulling numbers from various spreadsheets and software tools, and plugging them into your LFCF formula.

With Finmark from BILL, you can set up a custom formula to track LFCF as part of a fully customized financial reporting dashboard.

Automatically pull data in by connecting Finmark with the finance and accounting tools you’re already using, so you can spend less time with your head in the numbers and more time creating strategic plans for company growth.

Dive in today with a free 30-day trial of Finmark, the financial modeling and planning platform for startups and SMBs.