What is levered free cash flow?
Small business accounting is challenging, but if there’s one thing you can always count on, it’s that cash flow is still king. Too many small businesses fail because they are unable to manage day-to-day expenses.
We all know what cash flow is. But what is levered free cash flow? For that matter, what is unlevered cash flow, and what’s the difference between these two line items and your garden variety cash flow?
Let’s break it down.
Levered cash flow vs. unlevered cash flow vs. free cash flow
Levered cash flow is the amount of money your business has left over after paying all bills and other financial obligations, including operating expenses, interest payments, etc. Unlevered cash flow represents the money you have before paying all those bills.
You’ll also come across the term free cash flow (FCF), which is likely what you’re more familiar with. Free cash flow is the amount of money left over when all outflow is subtracted. Free cash flow indicates gross cash flow rather than net.
Unlevered and levered cash flow will appear on your balance sheet as separate items. Each is critical, especially to potential partners, investors, or anyone interested in buying your company.
Levered cash flow shows potential for growth and expansion. If you need to purchase new equipment, hire new employees, or move into a larger space and are looking for financing, your lender will look at your levered cash flow numbers to determine your risk and potential for success.
Why the margin matters
The margin between levered and unlevered cash flow numbers is a strong indicator of a company’s financial health. For example, if your company’s expenses exceed its earnings, you’ll have a negative levered cash flow. And though this is not an ideal situation, it may be temporary and thus may not cause too much concern about whether your business is financially healthy— but it all depends on who you ask.
Equity holders are more concerned with your levered cash flow. On the other hand, your debt partners (lenders) are focused on unlevered cash flow as the better indicator. It boils down to different stakeholders having different priorities.
Why levered free cash flow is critical for your small business
No business can — or should — remain static forever. At some point, you’ll want to grow and expand. When the time comes, you’ll need to have a few things in hand, not the least of which is the money to make it happen.
Growth comes in many forms. It could be as simple as digitizing and automating your processes so you can get more done in less time and with fewer people. Or, you might be ready to expand into a new market, add new products or services, develop new software, buy new equipment, or hire new employees.
Some companies can achieve the growth they desire without obtaining outside financing. But more ambitious plans often need to be funded by equity stakeholders (investors or partners that have a stake in the company) or through debt financing, i.e., from a bank or private lender.
Your levered free cash flow (LFCF) is critical in either scenario. Your investors (even if it’s just you) need to know that the business can meet its obligations. If the LFCF is not strong, it appears to potential investors and lenders that you are not a reasonable risk.
Ultimately, before you charge forward with plans to expand or take on more debt, your company’s LFCF is something you need to know. Much like knowing your credit score before you apply for a mortgage, it’s better to be prepared to get ahead of potential challenges.
Levered free cash flow formula
To calculate your levered free cash flow, you’ll need to gather some key pieces of information.
- Earnings Before Interest, Taxation, Depreciation, and Amortization (EBITDA). This basic calculation indicates a company’s financial performance in a broad sense
- Everything your company owes to its debtors, also known as mandatory debt payments
- Working capital, i.e., any available funds
- Investments in fixed assets, like equipment, property, buildings, etc., are otherwise known as capital expenditures
To calculate your LFCF, use this equation:
LFCF = ((EBITDA – mandatory debt payments) – change in net working capital) – capital expenditures
When complete, you might end up with a negative number despite having positive cash flow. If your LFCF is negative, it means your company doesn’t have enough money to cover its current financial obligations.
Some lenders may see negative LFCF as too great of a risk, but that does not mean your company is not profitable or doesn’t have financial stability. For example, if the company owns real estate, you might end up with a negative number. However, owning property could be more profitable for the business down the line. Smart investors will look at these details keenly and factor them into the bigger picture.
So, when you look at the difference between your unlevered free cash flow (your cash flow before you’ve paid all your obligations) and your levered free cash flow, you’ll clearly see the amount of debt you have, and that’s always good to know.
As for investors and lenders, levered cash flow is a more valuable metric. This is the number they will use to inform their decisions.
How to improve your levered free cash flow: 10 tips you can use right now
Ultimately, the best way to improve your LFCF is to reduce debt and increase income. If you increase revenue, your levered free cash flow will swing positive and put you on more solid ground over the long term.
Here are 10 tips to help you improve cash flow:
1. Study your operating cash flow to identify patterns
If your cash flow tends to swing wildly from one month to the next, there’s usually a reason. If you have historical data, drill down to identify trends. Knowing what to expect is more than half the battle. Cash flow projections help you optimize your efforts and prepare for leaner times well ahead of an approaching downturn.
2. Take online payments
If you still rely on mailed invoices and paper checks to get paid, you’re likely waiting an average of three weeks longer than you would if you accepted online payments.
Switching to an online invoicing system has many benefits. It’s greener because there’s less paper and waste. It takes less time to do the work because all your payments are tracked, viewed, and managed through your payment system. Plus, online payments and invoicing simplify your accounting workflows, making light work of a task that’s inherently tedious and error-prone.
Invoice2go Money Card Payments enables your customers to pay any way they like, including secure ACH bank transfers. Payments are processed and transferred to your linked bank account the next business day, and you’ll have all the financial data you need to assess your cash flow at your fingertips.
Once you’ve created your account, you’ll be ready to accept online payments within 24 hours and can reduce your workload even more with automated recurring invoices, automatic transfers, and more.
3. Incentivize your customers to get paid quickly
Positive cash flow hinges on your company’s ability to get paid quickly. Offering online payments and multiple ways for them to pay is a great place to start, but just because you’ve made it easy doesn’t mean all your customers will get on board. Think about offering incentives for fast payers, such as loyalty points, bonus discounts for so many consecutive months of on-time payments, an upgrade, or a percentage discount on future purchases for paying before the due date.
By the same token, look into whether some of your vendors offer the same type of incentive or whether you can extend your due dates to optimize cash flow.
4. Start forecasting future sales
Further to our first point, forecasting future sales helps you understand the income and outflow of your business over a set period. You can use historical data to project or predict what’s coming down the pike if you've been in business a while. Forecasting acts as a financial roadmap, giving you at-a-glance knowledge of your company’s financial performance and helping you plan your expenditures and initiatives strategically.
For instance, if you’re a landscaping contractor, you know your busy time is May through October. You can plan to pay down debt a little more or structure balloon payments during those times. It also allows you to know how much cash you’ll need to carry you through the slower seasons or mitigate issues before they become problematic. Projections also help you identify shortfalls as they’re happening, such as if sales are not meeting projections, so you can then determine the root cause and correct it before there is any fallout.
5. Reduce spending
Business expenses can be sneaky. But it pays to stay on top of all your expenditures to ensure they’re adding value and not undermining your company’s financial health. For example, suppose your employees have been working from home and you’re still paying for a traditional office space. In that case, that’s a considerable expense for physical space that you could probably do without.
Examine all your operational expenses and determine whether they serve a purpose. You can reduce even long-standing contracts sometimes. Take a look at your service agreements. If there are services you’re paying for that you no longer use, renegotiate. Shop around to see what others are paying. If you find a better deal elsewhere, ask your current vendor to meet that price. You might be surprised at how much you can save!
One of the first expenses you should look at is your payment processing and banking fees. Does your bank charge you for transfers? Are your transaction fees as low as they can be? Most banks charge a premium for business banking, but Invoice2go small business banking is a different way to do business. Our small business banking solution is designed for small businesses, offering the security of a big bank without the fees. Plus, you’ll get a Visa business debit card, a robust reporting module, and complete flexibility to help you manage and improve your cash flow.
6. Lease vs. purchase equipment
Equipment leasing is a much less costly option than buying, and you’ll often get a better rate than you would through a traditional lender. Your payments will be smaller and more manageable. And depending on your lease agreement, it will be easier to upgrade to the latest version of the equipment at the end of the lease, or you can purchase it outright for a small buyout fee. Leased equipment often includes the cost of maintenance, which may also save you some money.
7. Optimize your inventory
Whether you sell services or physical products, take the time to assess each item's performance periodically. If an item is not selling well or is costing you more than it’s worth, it may be time to do a cull. Underperforming products take up space you could allocate to more profitable items. There’s no point wasting energy marketing items that people aren’t buying.
8. Revisit your pricing structure
We’re living through one of the biggest inflationary periods in recent history, and no matter what your business is, it’s likely your costs have gone up. It’s good to revisit your pricing strategy at least once a year to ensure your products and services are priced fairly and represent market value. If you plan your increases and reach out to your customers to tell them why and when your prices are going up, they will usually understand.
9. Invoice factoring
Invoice factoring is an approach large companies often use to boost their cash flow. In a nutshell, factoring is getting an advance on money you’re owed based on outstanding invoices. A third-party company, known as a factor, purchases your unpaid invoices at a discount and takes over the collection process.
The factor generally pays between 80-90% of the invoice upfront and the balance when the invoice is paid, minus their fee. If you have a lot of outstanding invoices and your company’s cash flow is suffering because of it, factoring might be a good short-term solution.
To offer a real-world example, consider a large catering or event company that often needs to outlay significant amounts of cash before the final invoice is paid. It’s a bit of a chess game, and even a short gap has been known to ruin companies, especially if they have outstanding invoices from previous clients. Factoring can be an excellent option in this situation, ensuring everybody gets paid, enabling the event to go on without a hitch, and often leading to repeat business. Improving your levered free cash flow is vital for any small business looking to grow.