Income Isn't Cash: A deep dive into cash flow metrics

There's an old saying:

"[Revenue] is vanity, profit is sanity, cash is a reality."

Although frequently cited, it's origins aren't documented.

Meaning, it's what we call "folk wisdom".

That is, it bears a truth widely recognized within the community it came from.

I don't have a background in finance. So, for me, it highlights an important point that I didn't previously understand:

Income isn't cash.

For example, these companies have negative Net Income, but a lot of "Free Cash Flow" (FCF):

Bristol Myers Squibb has negative Net Income due to a large one-time expense related to acquiring "in-process research and development" (products that're still under development and not yet ready for production) [1, 2, 3]. But, their business is generating cash without issue.

British American Tobacco has negative Net Income because they're writing off the value of their deteriorating cigarette business [4]. But, they're generating cash without issue, too.

Looking at the reverse situation, these companies have a lot of Net Income, but negative Free Cash Flow:

Notice they're mostly banks.

Banks tend to look like this because their cash flow is affected by deposits, loans, etc. It doesn't mean they're not performing well. It's just that the nature of their business causes their financial metrics to look different than businesses in other industries.

When evaluating whether to invest in a business, here're a bunch of things we might want to think about:

• Profitability

• Whether profitability is sustainable

• Operational efficiency

• Financial efficiency

• Resilience to financial stress

• The ability to fund growth of the business

• The ability to pay dividends

• Intrinsic value

• How the business compares to:

  • Businesses in the same industry

  • Businesses in different industries

  • Businesses using a similar approach to funding

  • Businesses using a different approach to funding

There's no single number that can give us insight into all that.

So, in this article, we'll go over these important metrics:

• Net Income

• Earnings Before Interest and Taxes (EBIT)

• Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

• Operating Cash Flow (OCF)

• Free Cash Flow (FCF)

• Unlevered Free Cash Flow (UFCF)

• Levered Free Cash Flow (LFCF)

We'll also touch on the following terms along the way (but save deeper discussion for another time):

• Working Capital

• Current Assets

• Current Liabilities

• Change in Working Capital

• Depreciation

• Amortization

But first, we need to clarify something important...

Income isn't cash

Isn't a business's Net Income the cash it makes?

Unfortunately, it's not that simple.

Financial reports are meant to give a broad view of a business's financial health.

This includes non-cash income and expenses.

Non-cash income and expenses?

Yeah, it sounds weird.

But, let's think of "income" as value flowing into a business rather than cash.

And, let's think of "expenses" as value flowing out of a business.

Then, a business's non-cash income could include:

• Recognition of Deferred Revenue: Revenue reported when the business delivers a product, even though the cash payment was received in a previous period

• Income from Investments in Other Companies: The company's share of the Net Income from a separate company it partially owns

And, its non-cash expenses could include:

• Depreciation: Reductions in value of physical assets (like vehicles) as they age

• Amortization: Reductions in value of non-physical assets (like patents) as they age

• Impairment Charges: Losses in value of assets (like property) due to reassessing their value

• Stock-based Compensation: The value of stock options or shares issued to employees as compensation

• Bad Debt: Money owed to the company that the company now believes it'll never receive

Each of these represent value flowing into, or out of, a company.

But, they're not cash flowing in or out.

Remember that Net Income is: A company's total income minus all expenses and income taxes.

Note: If you want a refresher on income, check out how income flows through a business.

Since Net Income includes non-cash income and expenses, it's not the same as cash.

Income metrics tell us about the productivity and efficiency of a business.

But, we'll need other metrics to evaluate businesses' ability to generate cash.

Working Capital (WC)

Working Capital represents a company's ability to meet its near-term financial obligations.

That is, whether its cash and cash-like assets (Current Assets) exceed its near-term financial obligations (Current Liabilities).

Formally, Working Capital is:

Working Capital = Current Assets − Current Liabilities

Here're some things we might see under Current Assets and Current Liabilities on the balance sheet of a financial report:

For evaluating a company's cash-generating abilities, we only care about items related to operations. (That is, items with "Yes" in the "Related to Operations?" column.)

That's because a business generates cash through its operations.

So, a better definition of Working Capital for our purposes is [5]:

Working Capital = Current Operational Assets - Current Operational Liabilities

Note: Sometimes this operations-focused version of Working Capital is called Net Working Capital (NWC) [6]. But, sometimes Net Working Capital is also used to refer to the more general definition of Working Capital. Because of the inconsistency, we need to figure out which is being referred to whenever we come across any version of the term.

That means that for our purposes, Working Capital represents the balance of a company's cash-like operational assets and its near-term operational financial obligations.

But, what does (Operational) Working Capital have to do with cash flows?

Let's think of it this way:

1. If Current Operational Assets increased: Cash was "spent" to acquire assets

2. If Current Operational Assets decreased: Cash was "received" for giving up assets

3. If Current Operational Liabilities increased: Cash was "received" taking on liabilities

4. If Current Operational Liabilities decreased: Cash was "spent" to settle liabilities

"Spent" and "received" are in quotes because the actual cash movements are often a few steps removed from the changes to the Working Capital items.

But, the concept works well enough for now. And it keeps things simple.

So, building on that:

1. If Working Capital increases: Cash was "spent" (flowed out of the business)

2. If Working Capital decreases: Cash was "received" (flowed into the business)

Thus, changes in Working Capital are flows of cash.

The change in the value of Working Capital from one period to another is called: Change in Working Capital.

Since Change in Working Capital is a flow of cash, we need to account for it in cash flow calculations.

We'll see this as we take a closer look at individual cash flow metrics.

Meanwhile, here's a real example of Current Assets and Liabilities. It's from Apple's Q3 2024 quarterly report (10-Q) [7]:

And here's an example of cash flows from changes in these assets as seen in the company's cash flow statement:

Note: Cash flow statements include a section with a name like "Changes in operating assets and liabilities". That section generally lists the items we'd want to use to calculate the reporting company's Change in Working Capital.

Sometimes the list references non-current assets and non-current liabilities. That’s because it’s possible for long-term assets and liabilities to affect Working Capital. In the case above, the non-current assets and liabilities referenced are operating leases. This can be seen in Apple’s 2023 annual report (10-K) under Note 8 [8].

If using the numbers reported to calculate Change in Working Capital, make sure the time period the numbers are reported for is the time period you want. Notice that the numbers reported above are for a 9-month period. We need to do a bit more work if we want the numbers for a different period.

Note: Positive or negative values for Working Capital and Change in Working Capital shouldn't be interpreted as good or bad without understanding the full context. For example, if Working Capital is positive because the company has a large amount of inventory it's been unable to sell, it's likely a sign of weakness in the business. If Working Capital is positive because a large number of sales were added to accounts receivable until the purchase products are delivered, it's like a sign of strength in the business.

Financing decisions aren't operational efficiency

There're a lot of ways a company can fund its business operations.

But, they fall into three primary categories:

Note: Internal financing could also be viewed as a subcategory of equity financing. This is because it uses funds that're actually owned by share holders. Instead of funding growth, the funds could be distributed to share holders as dividends.

Companies usually fund their businesses with a mix of funding sources.

Most companies with publicly listed stock (equity-funded) also have debt and channel some of their profits towards growing the business.

It's a question choosing a mix that's likely to result in a good outcome for stakeholders.

The unique mix of funding a company uses is referred to as its Capital Structure.

A company's Capital Structure matters because it:

• Provides capital for maintaining or growing the business

• Creates external financial obligations

• Influences the expectations of stakeholders

It plays into the profitability and cash flow metrics we'll look at because it affects interest expenses, income taxes, etc.

And, with that, we're ready to start looking at those metrics.

Let's go!

Earnings Before Interest and Taxes (EBIT)

EBIT is: A view of a business's profitability without the impact of it's capital structure or tax situation.

It's calculated as follows:

EBIT = Net Income + Interest Expenses + Income Taxes

Why do we add interest expenses and income taxes?

Recall that Net Income is total income minus all expenses and income taxes.

So, we're adding back interest expenses and income taxes to go back to "before interest and taxes".

When we do this, it allows us to focus more on the profitability of business operations. This is because financing choices and income taxes aren't reflections of operating efficiency.

That's not to imply that it's not important to consider the impact of financing choices and taxes.

It is.

But, we should do both:

• Evaluate the company based on it's core business profitability

• Evaluate the company with the impact of its capital structure and tax situation

In summary:

EBIT's useful for:

• Evaluating a business's profitability without distortions from financing choices and income taxes

• Comparing companies with different capital structures

• Comparing companies with different tax situations

Its strengths as a metric include:

• It allows viewing profitability prior to impact of financing choices

• It allows viewing profitability prior to impact of the company's tax situation

• It's less volatile than cash flows, which are heavily influenced by one-time expenses

• Unlike EBITDA (which we'll cover next), it accounts for the costs of depreciation and amortization of assets

• It's simple to calculate

Its weaknesses include:

• It can be manipulated by the company's choice of depreciation method since it doesn't exclude depreciation and amortization

• It doesn't tell us how much actual cash was generated (it includes non-cash items)

Note: Some resources (like this article on EBIT) say EBIT is the same as Operating Income. That's not correct. There's some conceptual overlap between them, but they're not the same.

Operating Profit is: Gross Income - OPEX. It doesn't account for Other Income and Expenses.

EBIT is: Net Income + Interest Expenses + Income Taxes. Net Income includes Other Income and Expenses. So, unlike Operating Profit, EBIT includes Other Income and Expenses.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

EBITDA is: A view of a business's profitability without the impact of it's capital structure, tax situation, or method of depreciating assets.

It's calculated as follows:

EBITDA = Net Income
    + Interest Expenses
    + Income Taxes
    + Depreciation
    + Amortization

This is equivalent to:

EBITDA = EBIT + Depreciation + Amortization

Here's a visualization:

Like EBIT, EBITDA's another view of operational profitability.

But, it addresses one of the weaknesses of EBIT by removing the impact of depreciation and amortization.

This doesn’t imply that EBIT’s less useful.

They're just different views and each tells us something useful.

To help relate EBIT and EBITDA to operational metrics, here's a more end-to-end visualization of them:

In summary:

EBITDA's useful for:

• Evaluating a business's profitability without distortions from financing choices, income taxes, or choice of depreciation method

• Comparing companies with different capital structures

• Comparing companies with differet tax situations

• Comparing companies in capital intensive industries (i.e. companies that have significant long-lived assets that depreciate over time)

Its strengths as a metric include:

• It allows viewing profitability prior to impact of financing choices

• It allows viewing profitability prior to impact of the company's tax situation

• It's less volatile than cash flows, which are heavily influenced by one-time expenses

• Unlike EBIT it can't be manipulated by the company's choice of depreciation method since it excludes depreciation and amortization

• It's simple to calculate

Its weaknesses include:

• It doesn't include depreciation and amortization, which represent real and necessary costs to the business

• It doesn't tell us how much actual cash was generated (it includes non-cash items)

Note: Warren Buffet's warned that it's easy to be fooled when companies or analysts over-emphasize EBITDA. He explains his views in his response to an audience question at Berkshire Hathaway's 2003 annual meeting. If you don't want hear the whole explanation, but want to hear Charlie Munger call EBITDA "bullshit earnings", you can jump to this point in the recording instead.

Operating Cash Flow (OCF)

Alternative name(s): "Cash From Operations", "Cash Flow From Operations (CFFO)", "Net Cash Provided by (or Used in) Operating Activities", "Cash Generated by (or Used by) Operating Activities"

Operating Cash Flow is: The cash generated by a business’s operating activities.

It's calculated as follows:

Operating Cash Flow = Net Income
   + Depreciation
   + Amortization
   + Other Non-cash Expenses
   - Non-cash Income
   - Change in Working Capital

As can be seen, it:

1. Starts with Net Income

2. Adds back non-cash expenses, like depreciation, amortization, etc.

3. Removes non-cash income

4. Subtracts the Change in Working Capital (since cash flows out when Working Capital increases)

This gives us a view of the cash generated by a business before any of it's spent on investing and financing activities.

What're investing and financing activities?

Here's an example of from Apple's Q3 2024 quarterly report (10-Q) [7]:

As it happens, Operating Cash Flow is also calculated for us in the 10-Q:

So, we don't have to calculate it! 🎉

Note: When looking at info in a quarterly report (10-Q), it's important to be aware of the period over which the cash flow information is being reported. In the cash flow statement above, it's reporting cash flow for the past 9 months. That is, it includes 3 quarters of cash flow rather than just the cash flow for the quarter being reported on. Unfortunately, that means we do need to do some calculations if we need Operating Cash Flow for a different period of time.

To help relate Operating Cash Flow to operational metrics, here's a more end-to-end visualization:

In summary:

Operating Cash Flow's useful for:

• Evaluating a business’s core ability to generate cash

Its strengths as a metric include:

• It allows us to view the full cash-generating abilities of a business's operations

Its weaknesses include:

• It doesn't provide a good view of profitability since it excludes important non-cash income and expenses

• It doesn't tell us about sustainability of of the business since it doesn't subtract out spending required to sustain the business

• It doesn't tell us how much money's available to return value to equity holders since it doesn't subtract out required spending or required repayments of debt principal

Free Cash Flow (FCF)

Free Cash Flow is: The cash generated by a business's operating activities after removing the spending required to sustain those activities.

The spending required to sustain a business's operating activities is called Capital Expenditure.

Capital Expenditure (CAPEX) is: Purchases of assets with long productive lifespans for the purpose of sustaining or expanding a business's operating activities.

Free Cash Flow's calculated as follows:

Free Cash Flow = Operating Cash Flow − CAPEX

Free Cash Flow addresses a weakness in the Operating Cash Flow metric.

It's easy to see this from the formula: Free Cash Flow takes Operating Cash Flow and accounts for the spending required to continue generating cash flow into the future.

Much of a business's value comes from it's ability to continue generating profits and cash flow in the future.

If that ability isn't maintained, profits and cash flow will deteriorate.

So Capital Expenditure (CAPEX) is important. Free Cash Flow takes it into account.

What kinds of purchases are considered CAPEX?

Some examples include machinery for production and patents needed to develop new products.

Basically, they're things important to a business's ongoing operations that'll be used over a long period of time (over numerous reporting periods).

Here's Apple's CAPEX from it's 2023 annual report (10-K) [8]:

And, here's a footnote showing what kinds of assets Apple's purchased via CAPEX:

Note: We look at Apple's annual report (10-K) here instead of one of its quarterly reports (10-Q's) because the annual report has more examples of CAPEX spending. It represents an entire year of spending rather than just 1 quarter of spending.

So, we see why Free Cash Flow's a useful metric. But, what about its name?

What makes Free Cash Flow "free"?

Basically, it's "free" in the sense that it's available for management to spend as they see fit.

At the point of Free Cash Flow, operations have been funded and taxes have been paid (or provisioned). What remains is paying down debt and returning value to equity holders.

Management can use this cash to:

1. Make required payments on debt principal

2. Make extra payments on debt principal (to accelerate the reduction of debt)

3. Buy back stock

4. Pay dividends to share holders

5. Re-invest in the business (e.g. spend money to expand the business's cash-generating abilities)

Note: Required payments on debt principal obviously aren't optional. But, using debt to fund the business is. If management chooses to use debt, they’re choosing to use future cash generated by the business to make the required payments. So, when the company makes required debt payments, we view the spending as a (past) choice made by management.

To help relate Free Cash Flow to operational metrics, here's a more end-to-end visualization:

In summary:

Free Cash Flow's useful for:

• Evaluating the sustainability of a business's operations

• Evaluating a business's financial flexibility

Its strengths as a metric include:

• It accounts for spending required to maintain the business

• It provides a view of cash generated by the business before management chose what to do with it

Its weaknesses include:

• It can be volatile because Capital Expenditure (CAPEX) can be volatile

• It doesn't reflect required repayments of debt principal

• It doesn't tell us how much cash the business generates regardless of Capital Structure (while it doesn't account for repayments of debt principal, it does account for interest expenses)

Note: We've mentioned Depreciation several times up to this point. As a reminder, Depreciation is the gradual expensing of a long-lasting asset for the duration over which it's usable. At this point, we can view it in a broader context: (1) the company generates cash from its business, (2) it uses some of that cash to buy production machinery (a CAPEX purchase) (3) instead of expensing the purchase all at once, it expenses it in small chunks as the asset gets used/ages. Depreciation smooths out the significant fluctuations CAPEX spending would otherwise cause to profitability metrics.

Unlevered Free Cash Flow (UFCF)

Alternative name(s): "Free Cash Flow to Firm" (FCFF)

Unlevered Free Cash Flow is: The cash generated by a business's operating activities, excluding the impact of its Capital Structure (especially debt).

It's calculated as follows:

UFCF = EBIT × (1 − Tax Rate)
    + Depreciation
    + Amortization
    − CAPEX
    − Change in Working Capital

Personally, I think the following equivalent's a bit more intuitive:

UFCF = EBIT
    - (EBIT × Tax Rate)
    + Depreciation
    + Amortization
    − CAPEX
    − Change in Working Capital

In more words: Unlevered Free Cash Flow is the cash a business generates before any expenses or cash payments related to the company's Capital Structure are accounted for. It's the cash flow before interest expenses, debt principal repayments, dividends, etc.

But, those expenses and uses of cash are real costs to the business. Why would we be want a view of cash flow that excludes them?

Mainly because Capital Structure can change.

Debt can be added, paid off, or replaced with debt that has a different interest rate. And, equity can be bought out. Lots of things can happen that change a company's Capital Structure.

So, this view lets us see the cash that's generated before accounting for the costs of the Capital Structure.

Imagine a company wants to acquire another company.

Looking at the Unlevered Free Cash Flow of the target company would help the acquirer evaluate whether potential benefits from changing the target's Capital Structure. For example, increasing cash flow by by replacing high-interest debt with low-interest debt. Or by adding additional debt to make an acquisition they otherwise wouldn't have the funds for.

Unlevered Free Cash Flow is also a key component of one of the most important methods of valuing companies: Discounted Cash Flow (DCF).

DCF is a big topic, so we'll save in-depth discussion for another time.

For now, let's just note that Unlevered Free Cash Flow gets a lot of its importance from its use in DCF valuations.

Let's break down the formula for Unlevered Free Cash Flow:

• EBIT: This is earnings before interest and taxes. Using earnings “before interest” helps make Unlevered Free Cash Flow "unlevered" (exclusive of debt).

• EBIT × Tax Rate: This is the amount of taxes the company would pay on its earnings if it had no interest expenses. The formula includes this because taxes have to be paid on earnings regardless of what the Capital Structure is.

• Depreciation and Amortization: These're non-cash expenses. So, we need to reverse their effects like we do for other cash flow calculations.

• Capital Expenditure (CAPEX): Like with Free Cash Flow, we want to account for spending required to maintain the business's cash generating abilities.

• Change in Working Capital: This is a flow of cash. So, like with other cash flow calculations, we want to account for it.

You might notice that we reverse the effect of the non-cash expenses of Depreciation and Amortization, but not other non-cash expenses (and income).

Wouldn't it be more accurate to reverse those as well?

It could be.

But, trying to do so gets real complicated, real fast.

The formula generally works as-is because:

• Even though Depreciation and Amortization are non-cash expenses, they reduce the amount of cash owed for taxes. The formula retains the impact of Depreciation and Amortization on taxes by using EBIT to represent earnings (EBIT’s before interest and taxes, but after Depreciation and Amortization).

• Depreciation and Amortization are the long-term expensing of CAPEX. The formula accounts for the cash expenditure of CAPEX directly. So, reversing Depreciation and Amortization not only removes non-cash expenses, but also prevents double-counting CAPEX.

• Non-cash items aside from Depreciation and Amortization are more likely to have company-specific peculiarities. So, there's less standardization on how to treat them. Figuring out how to properly reverse their effects would take substantial time and effort. Even if we come up with a solution, it carries higher risk of mistakes and of being misunderstood by others.

• When using Unlevered Free Cash Flow to do a Discounted Cash Flow valuation, it’s best to include certain non-cash expenses like stock-based compensation. This factors the dilution caused by stock-based compensation into the valuation. Another way to think about this is that stock-based compensation is part of total employee compensation. It it’s removed, we'll need to give employees the equivalent in cash to ensure they're properly compensated.

• Reversing the effects of other non-cash items may result in a relatively insignificant change to the calculated value.

When looking at Unlevered Free Cash Flow, or calculations that depend on it (like Discounted Cash Flow valuations), it's definitely worth knowing what non-cash expenses and income it includes.

But, it's usually not worth modifying the formula.

In summary:

Unlevered Free Cash Flow's useful for:

• Evaluating a business's cash-generating ability without the effects of the company's Capital Structure (especially debt)

• Calculating valuations like the Discounted Cash Flow valuation

• Comparing the cash-generating capabilities of companies with different Capital Structures

Its strengths as a metric include:

• It excludes the impact of Capital Structure (especially debt)

Its weaknesses include:

• It doesn't account for the real obligations the company has to meet due to its existing Capital Structure

Levered Free Cash Flow (LFCF)

Alternative name(s): "Free Cash Flow to Equity" (FCFE)

Levered Free Cash Flow is: The cash generated by a business's operating activities that's available to return value to equity holders.

It's calculated as follows:

LFCF = Net Income
    + Depreciation
    + Amortization
    − CAPEX
    − Change in Working Capital
    − Repayments of Debt Principal
    + Newly Issued Debt

Said another way, Levered Free Cash Flow's a view of cash flow after accounting for all spending that has priority over rewarding equity holders.

The formula accounts for that spending because:

• Production and operational expenses are accounted for in Net Income

• It adjusts for Capital Expenditure (CAPEX) directly

• It adjusts for Change in Working Capital directly

• It adjusts for Repayments of Debt Principal directly

• Interest Expenses from debt are accounted for in Net Income

The reasons for not removing non-cash items other than Depreciation and Amortization are similar to the reasons for not removing them from Unlevered Free Cash Flow.

The remaining cash can be used for things like:

• Dividends

• Share buybacks

• Investments

• Acquisitions

• Increasing holdings of cash and cash-equivalents

  • Provides cushion for any difficult times in the future

  • May be used in the future for CAPEX to expand the business

  • May be used in the future to pay down debt

It’s worth noting that Levered Free Cash Flow includes any cash the company got from issuing new debt. That’s because that cash can be used for any of the same items above.

Like other cash flow metrics, a company's Levered Free Cash Flow only has meaning when evaluated in broader context.

A company could have low LFCF because it's investing heavily in CAPEX to expand the business. Or, it could be low because low profit margins prevent it from generating much cash.

A company could have high LFCF because it's underinvesting in CAPEX. Or, it could be high because the management's committed to returning capital to investors via dividends.

So, in addition to knowing what a company's Levered Free Cash Flow is, we also need to know why it's what it is.

Let's wrap up by taking a look at a visualization that shows how Unlevered Free Cash Flow and Levered Free Cash Flow relate to one another:

In summary:

Levered Free Cash Flow's useful for:

• Evaluating a company's ability to pay a dividend or do share buybacks

• Evaluating a company's ability to fund its own growth via its cash-generating ability

• Evaluating a company's ability to build a cash cushion for any challenging times it might face in the future

Its strengths as a metric include:

• It shows cash flow after all required spending is accounted for

Its weaknesses include:

• It's dependent on the company's current Capital Structure

• It doesn't separate out required and discretionary spending in the period it's calculated for (e.g. it doesn't differentiate CAPEX made to maintain the business from CAPEX made to expand the business)

Why do we have so many terms?

Each of the financial metrics we've looked at enable us to see the business from different perspectives.

Every company is unique in:

1. How it produces and sells it's products and services

2. How it funds its business

With so many possibilities, we need a lot of viewpoints into the company to accurately evaluate its current health and future potential.

Net Income, EBIT, and EBITDA are different perspectives on a business's profitability.

Operating Cash Flow, Free Cash Flow, Unlevered Free Cash Flow, and Levered Free Cash Flow are different perspectives on a business's ability to generate actual cash.

Here's a quick summary:

Each of these gives us an important view into a business's operational and/or cash-generating capabilities.

Summary of the formulas

Here's a summary of the formula's we've covered:

Net Income = Operating Income
    + Net Other Income
    - Income Taxes

[Earning Before Interest and Taxes]
EBIT = Net Income
    + Interest Expenses
    + Income Taxes

[Earnings Before Interest, Taxes, Depreciation, and Amortization]
EBITDA = Net Income
    + Interest Expenses
    + Income Taxes
    + Depreciation
    + Amortization

[Operating Cash Flow]
OCF = Net Income
    + Depreciation
    + Amortization
    + Other Non-cash Expenses
    - Non-cash Income
    - Change in Working Capital

[Free Cash Flow]
FCF = OCF - CAPEX

[Unlevered Free Cash Flow]
UFCF = EBIT × (1 − Tax Rate)
    + Depreciation
    + Amortization
    − CAPEX
    − Change in Working Capital

[Levered Free Cash Flow]
LFCF = Net Income
    + Depreciation
    + Amortization
    − CAPEX
    − Change in Working Capital
    − Repayments of Debt Principal
    + Newly Issued Debt

I find it interesting to explore how the metrics relate to one another. For example, looking at how to compute a particular metric from one of the others.

Below are a couple examples of doing this for Levered Free Cash Flow.

Levered Free Cash Flow's relationship with EBITDA:

[Base EBITDA formula → EBITDA-based Net Income formula]

EBITDA = Net Income + Interest Expenses + Income Taxes + Depreciation + Amortization

Net Income = EBITDA - Interest Expenses - Income Taxes - Depreciation - Amortization


[Base LFCF formula → EBITDA-based LFCF formula]

LFCF = Net Income + Depreciation + Amortization − CAPEX − Change in Working Capital − Repayments of Debt Principal + Newly Issued Debt

LFCF = EBITDA
    + Interest Expenses
    + Income Taxes
    − CAPEX
    − Change in Working Capital
    − Repayments of Debt Principal
    + Newly Issued Debt

Levered Free Cash Flow's relationship with Operating Cash Flow:

[Base OCF formula → OCF-based Net Income formula]

Operating Cash Flow = Net Income + Depreciation + Amortization + Other Non-cash Expenses - Non-cash Income - Change in Working Capital

Net Income = Operating Cash Flow - Depreciation - Amortization - Other Non-cash Expenses + Non-cash Income + Change in Working Capital


[Base LFCF formula → OCF-based LFCF formula]

LFCF = Net Income + Depreciation + Amortization − CAPEX − Change in Working Capital − Repayments of Debt Principal + Newly Issued Debt

LFCF = Operating Cash Flow
    - Other Non-cash Expenses
    + Non-cash Income
    − CAPEX
    − Repayments of Debt Principal
    + Newly Issued Debt

Levered Free Cash Flow's relationship with Free Cash Flow:

[Base FCF formula]

FCF = Operating Cash Flow − CAPEX

Operating Cash Flow = FCF + CAPEX


[OCF-based LFCF formula → FCF-based LFCF formula]

LFCF = Operating Cash Flow - Other Non-cash Expenses + Non-cash Income − CAPEX − Repayments of Debt Principal + Newly Issued Debt

LFCF = FCF
    - Other Non-cash Expenses
    + Non-cash Income
    − Repayments of Debt Principal
    + Newly Issued Debt

Levered Free Cash Flow's relationship with Unlevered Free Cash Flow:

[Base UFCF formula → UFCF-based Net Income Formula]

UFCF = EBIT × (1 − Tax Rate) + Depreciation + Amortization − CAPEX − Change in Working Capital

UFCF = EBIT - (EBIT × Tax Rate) + Depreciation + Amortization − CAPEX − Change in Working Capital

UFCF = (Net Income + Interest Expenses + Income Taxes) - (EBIT × Tax Rate) + Depreciation + Amortization − CAPEX − Change in Working Capital

Net Income = UFCF - Interest Expenses - Income Taxes + (EBIT × Tax Rate) - Depreciation - Amortization + CAPEX + Change in Working Capital


[Base LFCF formula → UFCF-base LFCF formula]

LFCF = Net Income + Depreciation + Amortization − CAPEX − Change in Working Capital − Repayments of Debt Principal + Newly Issued Debt

LFCF = UFCF - Interest Expenses - Income Taxes + (EBIT × Tax Rate) − Repayments of Debt Principal + Newly Issued Debt

LFCF = UFCF - Interest Expenses - ((EBIT + Interest Expenses) × Tax Rate) + (EBIT × Tax Rate) − Repayments of Debt Principal + Newly Issued Debt

LFCF = UFCF - Interest Expenses - (EBIT × Tax Rate) - (Interest Expenses × Tax Rate) + (EBIT × Tax Rate) − Repayments of Debt Principal + Newly Issued Debt

LFCF = UFCF - Interest Expenses - (Interest Expenses × Tax Rate) − Repayments of Debt Principal + Newly Issued Debt

LFCF = UFCF
    - Interest Expenses × (1 - Tax Rate)
    − Repayments of Debt Principal
    + Newly Issued Debt

Conclusion

We made it! 🎉

This article ended up being way longer than I initially expected.

Personally, I found it difficult to understand the concepts. But, after spending somewhere between 60 and 80 hours (literally!) of struggling through it, I think I got there.

I hope the result's intelligible and help you make sense of them without having to spend as much time as I did!

For the next one, I think I'll aim for something a little less intense. 😅

Until then, happy hunting!

References

Noted references:

1. Bristol Myers Squibb Q1 2024 Results. Bristol Myers Squibb. Retrieved 2024-09-03.

2. Bristol Myers Squibb Completes Acquisition of Karuna Therapeutics, Strengthening Neuroscience Portfolio. Bristol Myers Squibb. Retrieved 2024-09-03.

3. Nick Paul Taylor. BMS pays $800M upfront for antibody-drug conjugate, opening new front in Merck rivalry. Fierce Biotech. Retrieved 2024-09-03.

4. Jess Jones. British American Tobacco slumps to £15.7bn loss as higher impairment charge on US brands wipes out profit. Yahoo Finance. Retrieved 2024-09-03.

5. Brian DeChesare. The Change in Working Capital in Valuation and Financial Modeling. Breaking Into Wall Street. Retrieved 2024-09-04.

6. Net Working Capital (NWC). Wall Street Prep. Retrieved 2024-09-05.

7. Apple Inc. Q3 2024 Form 10-Q. As filed with the SEC. Retrieved 2024-09-05.

8. Apple Inc. 2023 Form 10-K. As filed with the SEC. Retrieved 2024-09-05.

Additional references:

1. EBIT Guide. CFI Education Inc. Retrieved 2024-08-30.

2. EBITDA. CFI Education Inc. Retrieved 2024-08-30.

3. Cash Flow from Operations (CFO). Wall Street Prep. Retrieved 2024-09-06.

4. Tim Vipond. Free Cash Flow (FCF) Formula. CFI Education Inc. Retrieved 2024-08-30.

5. Brian DeChesare. Unlevered Free Cash Flow Tutorial: Definition, Examples, and Formulas. Breaking Into Wall Street. Retrieved 2024-08-30.

6. FCFF vs FCFE. CFI Education Inc. Retrieved 2024-08-29.

7. Tim Vipond. The Ultimate Cash Flow Guide (EBITDA, CF, FCF, FCFE, FCFF). CFI Education Inc. Retrieved 2024-08-29.

8. Brian DeChesare. How to Calculate Free Cash Flow and What It Means. Breaking Into Wall Street. Retrieved 2024-08-30.

9. Operating Profit vs. EBIT: What’s the Difference?. Indeed. Retrieved 2024-08-30.

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