Levered free cash flow and unlevered free cash flow are two key measures of the cash generated by a business, but they serve different purposes in valuation. Unlevered free cash flow shows the free cash flows available to all providers of debt and equity capital before any debt payments are made. Levered free cash flow shows the cash flow to equity holders after the company has covered all debt servicing costs including interest expense and debt repayments. The free cash flow calculation for each starts from the same place but diverges based on whether debt costs are included or stripped out.
To calculate unlevered free cash flow, start with operating income from the cash flow statement, subtract taxes, add back items like write-offs that do not use cash, and subtract capital spending and changes in working capital. This figure represents the total cash generated by the business before any debt payments leave the picture. Because it ignores the capital structure, unlevered free cash flow lets analysts compare companies with very different levels of debt and equity on an equal footing. It pairs with the weighted average cost of capital as the discount rate in enterprise-level valuation models.
Levered free cash flow takes the analysis one step further by subtracting interest expense and debt repayments from the free cash flows. This gives the cash that actually belongs to equity holders after the company meets all its debt servicing duties. The levered free cash flow figure matters most to stock investors because it shows what is left for dividends, buybacks, or reinvestment after all operating expenses and debt payments have been covered. It pairs with the cost of equity as the discount rate when building equity-level valuation models.
The gap between levered free cash flow and unlevered free cash flow tells you how much of a company's cash generated goes toward debt servicing each period. A firm with heavy debt will show a large gap, meaning equity holders get a much smaller share of the total free cash flows. A firm with little or no debt will show nearly identical figures for both measures. This gap helps investors gauge financial risk and decide whether a company's long term ability to reward shareholders is being squeezed by too much borrowing.
Both measures play central roles in valuation. Unlevered free cash flow feeds into discounted cash flow models that use the weighted average cost of capital to find enterprise value. Levered free cash flow feeds into models that use the cost of equity to find equity value directly. The net income figure from the income statement is related but not the same, since net income includes non-cash items that the free cash flow calculation strips out. Understanding how each measure is built and when to use it helps investors make better long term decisions about which stocks deserve a place in their portfolios.