In a 2004 investor letter, Jeff Bezos said:
“Our ultimate financial measure is Free Cash Flow…”
Let’s dig into why he said this:
“Our ultimate financial measure is Free Cash Flow…”
Let’s dig into why he said this:
1/ As you read this thread, remember this principle:
• Revenue is Vanity
• Profit is Sanity
• Cash Flow is Reality
• Revenue is Vanity
• Profit is Sanity
• Cash Flow is Reality
2/ Flaws with Profit
One of the main reasons why Jeff Bezos made this statement is because:
Profit is an accounting measure and it has a number of flaws
Let’s take a look at 3 major flaws with profit:
One of the main reasons why Jeff Bezos made this statement is because:
Profit is an accounting measure and it has a number of flaws
Let’s take a look at 3 major flaws with profit:
3/ Flaw #1: Depreciation
Accounting rules dictate that you expense equipment purchases in increments over a number of years via depreciation
This does NOT match the cash outflow you incur when you buy equipment
Accounting rules dictate that you expense equipment purchases in increments over a number of years via depreciation
This does NOT match the cash outflow you incur when you buy equipment
4/ Flaw #2: Cost of Goods Sold
Accounting rules dictate that you expense inventory via Cost of Goods Sold
This does NOT match the cash outflow you incur when you buy inventory
Accounting rules dictate that you expense inventory via Cost of Goods Sold
This does NOT match the cash outflow you incur when you buy inventory
5/ Flaw #3: Accounts Receivable
Accounting rules dictate that you record sales on credit as revenue
This does NOT match the cash inflow you receive when you collect cash for sales on credit
Accounting rules dictate that you record sales on credit as revenue
This does NOT match the cash inflow you receive when you collect cash for sales on credit
If you’d like to learn more, I’ve covered the difference between “profit” and “cash flow” in a previous thread:
6/ What is Free Cash Flow?
Free Cash Flow is:
The cash flow a company earns every year after paying for Capital Expenditures or “Capex”
It is calculated as: Cash Flow - Capex
Free Cash Flow is:
The cash flow a company earns every year after paying for Capital Expenditures or “Capex”
It is calculated as: Cash Flow - Capex
7/ Capex
Why do we deduct “Capex” from Cash Flow?
Capex is the total amount of money a business spends to buy assets that generate income
Examples of assets include:
• Buildings
• Computer equipment
• Vehicles, etc.
Why do we deduct “Capex” from Cash Flow?
Capex is the total amount of money a business spends to buy assets that generate income
Examples of assets include:
• Buildings
• Computer equipment
• Vehicles, etc.
We deduct Capex because Cash Flow usually refers to “Operating Cash Flow”
Operating Cash Flow doesn’t take into account the cash you spend to buy assets
Operating Cash Flow doesn’t take into account the cash you spend to buy assets
For some businesses like oil and gas, Capex is a necessary cost of doing business
An oil company has to spend cash to buy more equipment to drill for oil
An oil company has to spend cash to buy more equipment to drill for oil
8/ Amazon
Here is a chart that compares amazon’s:
• Profit
• Cash Flow
• Free Cash Flow
Here is a chart that compares amazon’s:
• Profit
• Cash Flow
• Free Cash Flow
You will notice that amazon’s cash flow and free cash flow are higher than profit in almost every year
Why is this the case?
Why is this the case?
Amazon takes huge charges for depreciation which reduces profits
These depreciation charges are for assets that amazon is investing in to build its business
This causes a mismatch between profit and cash flow and makes profit appear artificially low
These depreciation charges are for assets that amazon is investing in to build its business
This causes a mismatch between profit and cash flow and makes profit appear artificially low
Therefore, you can conclude that in the case of amazon,
Profit is a less reliable measure to gauge amazon’s performance than cash flow
Profit is a less reliable measure to gauge amazon’s performance than cash flow
TL;DR
1. Profit has flaws
2. Cash Flow doesn’t account for Capex
3. Free Cash Flow is: Cash Flow - Capex
4. Mismatch between profit and cash flow
5. Profit is a less reliable measure
1. Profit has flaws
2. Cash Flow doesn’t account for Capex
3. Free Cash Flow is: Cash Flow - Capex
4. Mismatch between profit and cash flow
5. Profit is a less reliable measure
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