What Is Free Cash Flow?
Free Cash Flow (FCF) measures the actual cash a company generates that is truly "free" to be returned to investors, used to pay down debt, or reinvested in the business. Unlike EBITDA, FCF accounts for the real cash costs of capital expenditures and working capital changes.
Unlevered vs. Levered Free Cash Flow
Unlevered Free Cash Flow (UFCF) is the cash flow available to all capital providers β both debt and equity holders. It is calculated before interest payments and is used in DCF analysis discounted at WACC.
Levered Free Cash Flow (LFCF) is the cash flow available only to equity holders, calculated after interest payments and mandatory debt repayments. It is discounted at the cost of equity.
Calculating Unlevered Free Cash Flow
Start with EBIT. Apply the tax rate to get NOPAT (Net Operating Profit After Tax). Add back D&A (non-cash). Subtract capital expenditures. Subtract increases in net working capital (or add decreases).
Calculating Levered Free Cash Flow
Start with net income. Add back D&A. Subtract capex. Subtract increases in net working capital. Subtract mandatory debt repayments. Add any new debt raised.
Why FCF Matters More Than EBITDA
EBITDA overstates cash generation because it ignores capex and working capital needs. A company with $500M EBITDA but $400M in annual capex has only $100M in free cash flow before working capital β dramatically less than EBITDA suggests.
FCF also better captures the cash conversion quality of a business. The FCF conversion ratio (FCF/EBITDA) compares efficiency. Asset-light businesses like software companies often achieve 60-80% conversion, while capital-intensive industries convert only 20-40%.
Free Cash Flow Yield
FCF yield (FCF divided by Enterprise Value or market cap) compares cash returns across investments. A company trading at a 10% FCF yield generates $0.10 of free cash for every $1.00 of value.
FCF in Practice
FCF is the cash flow metric used in DCF models, dividend capacity analysis, debt repayment schedules in LBO models, and shareholder return analyses. It is a more reliable measure of value creation than any accrual-based metric.