Levered Free Cash Flow Formula
Small business accounting can be tricky. And unless you’re in finance, you likely didn’t start your venture so you could have your head buried in the books and crunching numbers.
But paying attention to your cash flow is so important to ensuring ongoing success. 30% of small businesses fail because they run out of cash.
That’s why you need to arm yourself with accounting 101 know-how so you can stay on top of your business’s financial health and profitability.
In this article, we’re looking at what levered free cash flow is, why you need it, and how to calculate it.
What does levered mean?
Before we get into the nitty gritty, let’s lay the groundwork on what we mean when we say “levered.” This means the business was funded with borrowed capital. Borrowed capital can come from small business loans, investors, or other external funding sources.
In some cases, the business was started on both borrowed and owned capital. A portion may have come from external sources while the remaining was paid for by the business itself. In other cases, though this is less common, the business was started entirely on borrowed capital.
When a business uses external funding, lenders have leverage, which is where we get the word levered from. Levered means the small business owes debtors and doesn’t completely own all of their capital.
What is levered free cash flow?
Levered free cash flow is how much capital your business has after you’ve accounted for all payments to your short- and long-term financial obligations. Levered free cash flow represents the money available to investors, company management, shareholder dividends, and investments back into the business — equity investors essentially.
Levered free cash flow is also referred to as levered cash flow, and is abbreviated as LFCF.
A business with negative LFCF may still be profitable and financially sustainable. For example, if you’ve made significant capital investments in physical space for a storefront or a warehouse, this could put you into a negative LFCF. But this doesn’t mean you won’t recuperate the “loss” in the long-term.
Negative LFCF isn’t always okay. Sometimes it means you’re spending more than you’re earning in your business. Regardless of the calculation of your LFCF, you always want to understand the why behind your numbers.
Levered free cash flow vs. unlevered free cash flow
Levered free cash flow is different from unlevered free cash flow because the latter assumes all capital is owned and none has been borrowed. In some contexts, this is the reality: SMBs can and do start up on their own financial accord. In others, this isn’t the reality.
So why use both?
Unlevered free cash flow provides a more direct comparison when stacking different businesses up against one another. Levered free cash flow, on the other hand, works in favor of the business that didn’t borrow any capital and doesn’t necessarily show a comparative analysis of each company’s ability to generate cash flow on an ongoing basis.
Which is better? If you’re looking at it purely from a numbers standpoint, unlevered free cash flow will make your business look better. But levered free cash flow is more accurate.
How to calculate levered free cash flow
The LFCF formula is as follows:
Levered free cash flow = earned income before interest, taxes, depreciation and amortization - change in net working capital - capital expenditures - mandatory debt payments
Abbreviated, it looks like this:
LFCF = EBITDA - change in net working capital - CAPEX - mandatory debt payments
Here’s what each of these means:
- Earnings before interest, taxes, depreciation, and amortization: EBITDA is an alternative to simple earnings or net income that you can use to determine overall financial performance
- Capital expenditures: CAPEX are investments in property, buildings, machines, equipment, and inventory, as well as accounts payable and accounts receivable
- Working capital: the total working capital a business has
- Mandatory debt payments: what a business owes to debtors — lenders, investors, interest, etc.
Levered free cash flow example
Now that we have our formula, we can put it to work with an example. Let’s say you operate a construction company. When you started your company three years ago, you put forth $100,000 of your own money and borrowed an additional $200,000. Each month, you owe a minimum of $10,000 on that debt.
In the first year, your EBITDA was $150,000. That figure grew to $250,000 in your second year and $350,000 in the third. Year 1 was also when you purchased all of your machinery for $275,000, you didn’t have any capital expenditures in the second year, and you spent $50,000 in the third. Year 1’s working capital was $50,000, $100,000 in Year 2, and $250,000 in Year 3. Here’s what this all looks like:
Year 1
Year 2
Year 3
EBITDA
$150,000
$250,000
$350,000
CAPEX
$275,000
$0
$50,000
Working capital
$50,000
$100,000 (100% change)
$250,000 (150% change)
Mandatory debt payments
$120,000
$120,000
$120,000
Let’s recall our LFCF formula:
LFCF = EBITDA - change in net working capital - CAPEX - mandatory debt payments
Now we’ll do the calculation for the first year:
LCFC = 150,000 - 50,000 - 275,000 - 120,000 = -$295,000
And the second year:
LFCF = 250,000 -50,000 - 0 - 120,000 = $80,000
And the third year:
LFCF = 350,000 - 150,000 - 50,000 - 120,000 = $30,000
These are representative of a healthy, financially thriving and sustainable business.
Moving forward with levered free cash flow
Just like with any other accounting KPI in your business, levered free cash flow doesn’t tell the full picture. You need to think beyond tunnel vision to understand your business’s holistic financial health, now and over time.
In addition to LFCF, there are other free cash flow formulas you can use to see your business’s financial viability. Get started with these: