Netflix reported $608 million in net income last quarter
but during the exact same time period it reported - $569 million in free cash flow.
What is the difference between those two numbers and which is more important watch this video to
the end to hear all those details my name is Brian Feroldi and my name is Brian Stoffel
thanks to Quartr for sponsoring today's video all right brian let's start off with some very
basic definitions what is net income well net income is the profit that remains after all
expenses and costs have been subtracted from your revenue net income is found by looking at the
very bottom line on the income statement now it's important to note that the income statement uses
accrual accounting what does that mean well it's a way of accounting that allows a company to record
revenue before receiving payment for goods or services sold or expenses are recorded as incurred
before the company has paid for them so if we look at the income statement from netflix in the
fourth quarter of 2021 we see that it reported $7.7 billion in revenue it had $7.1 billion in
expenses and that left a $607 million gain in net income sounds great now let's talk about
free cash flow what's free cash flow it's gonna sound really similar but what free cash flow is
is taking all the cash that is generated from running your business and simply subtracting out
capital expenditures which is when you spend money on property plant or equipment now free cash flow
is found by looking at the cash flow statement the formula is very simple it's operating cash
flow minus capital expenditures the difference between those two numbers is free cash flow
and it's really important to note that instead of accrual counting the cash flow statement uses cash
accounting in other words it simply measures money moving in and out of a business now as we've noted
before the income statement and the cash flow statement are linked to each other the very bottom
line of the income statement is net income and that ends up being the very top line of the cash
flow statement so if we look at netflix's fourth quarter of 2021 we see that they lost about $403
million dollars by running their business that's cash from operating activity they also spent about
$166 million dollars on capital expenditures you put those two together and the company's
free cash flow was a loss of $569 million dollars that's over a $1 billion difference from their
reported net income now what's interesting about that number is that's nothing new for netflix
and there's nothing nefarious going on if you look back to 2019 netflix reported a net income of $1.9
billion dollars during that period at the same time however they reported free cash flow losses
of $3.1 billion and now we're talking about a difference of $5 billion to understand why this is
happening it's important to dig into the details of how netflix pays for its content let's rewind
the clock to 2019 this is the year that netflix gave the thumbs up to its mega popular show
squid game so in 2019 when they approved the start of production netflix gave away a ton of money to
make the show which meant that netflix's cash balance went down that makes sense because the
actors directors set designers etc all wanted to be pay when they were making the show that means
that netflix has to fund the development of these products years before they actually are released
on the screen so if we go back to netflix's cash flow statement from 2019 we will see that they
spent nearly $14 billion dollars on addition to content assets that includes money that they paid
for the start of production for squid game now we need to fast forward to september of 2021
this is finally when squid game was available for viewing on netflix the show proved to
be enormously popular and the company reported that during the fourth quarter they gained eight
million subscribers now we can never know how many of those came just because of squid game but it's
worth figuring that at least some of them did so netflix was finally able to realize a cash balance
going up because of their investment in squid game so how does netflix account for the expense of
paying for squid game this is actually accounted for on both the income statement and the cash flow
statement let's go back to 2019. during the same year that it was starting production of squid game
it was also amortizing the cost of some older shows such as house of cards so there was nearly
nine billion dollars of content that had already been paid for but was being amortized during 2019
so to figure out what netflix's free cash flow was we take that negative $2.9 billion dollars
we subtract out about $250 million on capital expenditures and we arrive at the figure of
negative $3.1 billion dollars so if we were to summarize what netflix was doing with its capital
it would be essentially saying we're spending boatloads of money right now as shown on this
out that these very same dynamics can play out in the opposite direction and one critical example is
zoom video communication during the year 2020 zoom reported a positive net income of $672 million
pretty good but it gets even better when we look at free cash flow which was more than twice net
income at $1.4 billion so what's going on here well we have to break down zoom's business model
rewind the clock to march of 2020. that's when schools businesses and organizations everywhere
all of a sudden decided that they needed to become zoom's customers at that point in time they paid
for an annual subscription to zoom so they handed over a lot of money to the company so when this
happened zoom's bank account exploded higher driving huge gains in free cash flow but for
instance during that first quarter zoom could only recognize one month of payments from those schools
so its revenue only inched up a little bit so if we look at the company's financial statements for
the year we saw that zoom reported a net income of $672 million but the biggest difference on
the cash flow statement was deferred revenue which is another way of accounting for that
huge sum that all those schools businesses and organizations paid at the front of their period
so because Zoom's business model is to get paid before it actually renders a service that's why
free cash flow was so much higher than net income if we simply take the roughly $1.5 billion dollars
in cash provided by operating activities and subtract out a little bit of capital expenditures
we get $1.4 billion dollars in free cash flow so to compare and contrast netflix business model
naturally makes it look like net income is higher than free cash flow primarily because netflix has
to pay for content years before it can count as revenue zoom on the other hand has much higher
free cash flow than net income because it collects all of the cash before it's done rendering its
service now in my own framework i think looking at net income and free cash flow are both important
however there's a really important distinction as to why i think free cash flow is more important
than net income we'll explain all the details why next but before we do we want to give a shout
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search for quarter that's q-u-a-r-t-r all right brian so if we remember the anti-fragile framework
it's predicated on what happens when black swans hit for those that are unfamiliar a black swan is
a very rare very difficult to predict event that pretty much affects everything that happens after
it occurs now we're used to thinking about the world that's distributed in an even way
like this bell curve and that is still true with things like a coin flipping contest or the birth
weight of individuals but increasingly due to technology we live in this different world that
has long tails we call it extremistan and that is where a small number of data points account
for most of the difference think of it this way take the average income in your neighborhood and
now change it if jeff bezos were to move into your neighborhood tomorrow one person moving in average
changes dramatically now why is all this important when thinking about net income and free cash flow
well the reason is that 99 of the time the world is fairly predictable however we need to remember
that one percent or sometimes even less of the time a black swan arises and when these black
swans arrive they dramatically impact everything consider how much the world changed in the months
leading up to 9 11. not much impact at all however a simple five-hour window on that one morning
affected everything about how the world functioned moving forward so 99 of the time we live in a
predictable world where we can count on things like net income but one percent of the time we
live in an unpredictable world that's governed by black swans and when those events hit it's good to
have cash on hand that's why it's important to look at both things net income does give you a
good picture for how a company is being built for the long run but free cash flow is important for
when black swans hit and that's why it's all that matters for my framework now i think it's fair to
say that both of us will continue to look at net income and free cash flow indefinitely however
like you when i'm forced to choose between the two i'll personally take free cash flow
every single time now it's also worth noting that not all net income is created equally there's
huge differences in net income when you're looking at gaap or non-gaap accounting you
want to learn more about that subject click the link you see on your screen brian's out