free-cash-flow

What is Free Cash Flow? In Free Cash Flow We Trust

Free cash flow is the cash a company generates through its operations, once you take off the non-cash expenses, changes in working capital, and capital expenditures. Thus this is the cash “free” to distribution that a company can potentially invest back into the growth of the business.

In free cash flow, we trust

When you look at the financials of tech companies, be it Tesla, Amazon or any other so-called unicorn startups or tech company an interesting aspect is how bad they perform if you measure them in terms of the bottom line.

Indeed, when you look at revenue growth, many of those companies seem to be doing fine. Yet when you look at the net profit (the money left after you deduct all the expenses from operating the business plus tax and interests), you are left with nothing, if not a net loss.

Does it mean those tech companies are worth nothing if they are not able to have a net profit? Not necessarily but of course the bottom line is still an important metric. When we enter the startup and tech world, we often need other parameters to measure their impact, for a few reasons.

Ecosystems take time to build

Often, tech companies are opening up new spaces, industries and operate with new business models. Those industries, areas and business models are not stand-alone, and they often need several pieces to come together before a company can start being profitable.

Think for instance how Salesforce began to operate with – at the time – a new business model for enterprise SaaS, which relied on a subscription-based revenue model.

While Salesforce grew consistently and quickly in terms of revenues, it was unprofitable for quite some time:

salesforce-financials-2001-2003

Indeed, Salesforce 2018 finally posted a net income, after years of net losses. Today the SaaS business model has become the norm for most tech startups and massive industries.

Yet it took years to build a context that would allow a single company, like Salesforce to make a profit:

what-is-saas
Software as a service (SaaS) is a model where a third-party provider hosts the infrastructure and applications and make them available through the Internet. This model leverages web-based software and on-demand applications that run centrally on the server of the provider, while the company purchasing the service will use those applications based on need and without the upfront cost.

Growth over profitability

Another critical element is growth. As startups try to dominate a niche, space, industry, and marketplace, they emphasize growth rather than profitability.

spotify-business-model
Spotify is a two-sided marketplace where artists and music fans engage. Spotify has a free ad-supported service and a paid membership. Founded in 2008 with the belief that music should be universally accessible, it generated €9.66 billion in 2021. Of these revenues, 87.5% or €8.46 billion came from premium memberships, while over 12.5% or €1.2 billion came from ad-supported members.

In many cases, tech companies are not only offering new products but also adopting new business models that open up spaces that before didn’t exist. In this scenario, market domination becomes the rule.

Thus, metrics like user acquisition become the primary elements those companies focus on to judge whether the business is going in the right direction.

When you focus on growth, profitability will in many cases be affected negatively.

Thus, to build a more sustainable business model, often companies – that have been focusing on growth for years – will have to slow down a bit and allow their bottom line to keep up with the growth pace.

Free cash flow as a north star

is-amazon-profitable
Amazon was profitable in 2021. The company generated over $33 billion in net income, primarily driven by the Amazon AWS business, which contributed to over 55% of its operating margins and other profitable parts like Amazon Prime and Ads. The Amazon e-commerce platform runs at tight operating margins since it’s built for scale.
is-netflix-profitable
Netflix is a profitable company, which net profits were $5.1 billion in 2021. Growing from $2.7 billion in 2020. The company runs a negative cash flow business model, where it anticipates the costs of content development and licensing through the platform. Those costs get amortized over the years, as subscribers stick to the platform.

If you looked at Amazon’s financials in the early 2000s, you cloud notice a negative bottom line. Indeed, Amazon between 2001 and 2002 was operating with a net loss of over a hundred million dollars.

However, already in 2002 Amazon was generating cash from its operations.

Indeed, Amazon has been able over the years to create a built-in cash machine mechanism for its business model to generate a massive amount of cash independently from its profit margins:

cash-conversion-cycle-amazon

Thus, if we were looking at Amazon purely from its bottom line, we would assume the company would not be worth much. Yet Amazon – at the time of this writing – is among the tech companies with the highest market capitalization in the world.

Amazon managed to disrupt several industries and grow at fast speed thanks to its cash conversion cycle and its ability to generate cash from its operations.

Do we need to forget about the bottom line?

When Google showed its numbers back in the 2000s not only it was a company growing at a fast speed; but it was also extremely profitable. Indeed, besides the year 2000; in 2003 Google had already passed the billion revenue mark and had over a hundred million in net profit.

The same applies to Facebook. When the company made its IPO back in 2012, it had already a billion in net profit and over three billion in revenues. Both companies would become the largest tech giants of our days.

They had created new businesses, and technologies, and operated new business models; yet they were highly profitable.

Thus, looking at the bottom line in combination with other metrics more focus on cash generation is still critical.

However, it is essential to make a critical differentiation.

When a company is not able to be profitable due to its inability to figure out a sustainable business model, that makes it way riskier than other companies that instead are not profitable because they decided to emphasize cash generation and growth.

In other words, the fact that Amazon chooses to keep its profit margin low is a strategic decision.

Compared to an upcoming startup, that instead is operating at a net loss only because it can’t figure out yet a business model. In the latter scenario, the bottom line still matters!

How does Amazon compute its free cash flow?

free-cash-flows-Amazon

Example of how Amazon computes its free cash flows, from Amazon Q1 2020.

Connected Business Concepts

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Ratio

financial-ratio-formulas

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as a fixed asset, with a longer-term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

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