Why Free Cash Flows are called Unlevered Cash Flows?

Free Cash Flow (or FCF) is a widely used metric in finance and it is sometimes known as the unlevered cash flow. But before we dive deeper into why FCFs are called so, let's begin with what FCFs are.

What is Free Cash Flow?

Free Cash Flow is a cash component that a company retains after investing and distributing money to all kinds of debt outstanding in the market. FCF is a measure of the wellbeing of a company and so, it is of interest to the lenders and debt-holders of the company.

Simply put, FCF is the funds that remain after repaying all the creditors and investors. Usually, creditors and investors seek an interest on the amount they owe, and hence FCF must exclude the interest payments as well. Therefore, FCF is the indicator of a company's financial health. It is the power of a company to return the debt to the creditors and investors in a timely and structured manner.

Unlevered and Levered Free Cash Flow

There are two types of Free Cash Flows −

  • Free Cash Flow to the Firm (FCFF) is an indicator of the ability of a company of producing cash for capital expenditure.

  • Equity FCF (EFCF) is the FCF that is made available for the equity shareholders of the company.

FCFF is known as unlevered free cash flow, while EFCF is known as levered free cash flow.

Why is FCFF called Unlevered FCF?

Free Cash Flow to the Firm is called unlevered because it is independent of debt and interest payments.

  • FFCF is the net amount left after repaying the debts to creditors and investors along with a given return.

  • FCFF is not levered on debts or other forms of loans. FFCF is just the net amount left with the company for its own purpose which it can use to fund any new future project.

FCFF is used to produce cash for capital expenditure. The capital expenditures are related with external expenses a company may have from time to time. The capability of a firm to meet these expenditures is the ability to remain competitive in the market.

Usually, investors are interested to know the FCFF of a company because companies with a better FCFF can meet sudden and unforeseen expenses. Moreover, since there is no debt left to lever upon, the FCFF is free from risks to a large extent.

Since there is no debt portion left for payment to creditors, FCFF is free from leverage. Once the company is able to generate FCFF, it is considered unlevered. That is why, FCF is also known as unlevered cash flow.