What is free cash flow, and why is free cash flow such an important financial metric?
The best way to understand free cash flow is through real life examples.
Here’s a free cash flow case study for a company that most of you
will have heard of: Netflix.
If you want to understand how that business works,
it helps to understand how its financial statements work!
This video is for educational purposes only, none of the comments in this video should
be interpreted as investment advice.
The maker of this video does not hold a position in Netflix securities, and he doesn’t even
have a Netflix subscription!
As the video is for educational purposes, please do try this at home & comment on your
findings below!
Let’s take a high level look at Netflix financial performance for the past five years.
Revenue grew from $6.8 billion in 2015 to $20.2 billion in 2019, which translates to
a compound annual growth rate of over 30%.
Yes, you heard that right.
30% revenue growth per year!
Profitability, as measured by Net Income, grew from $123 million in 2015 to $1.9 billion
in 2019, a compound annual growth rate of nearly 100%.
Yes, you heard that right.
On average nearly doubling the Net Income year after year.
Cash flow, as measured by Free Cash Flow, went from negative $921 million in 2015 to
negative $3.3 billion in 2019, a compound annual growth rate of over 35%.
Yes, you heard that right.
On average, the Free Cash Flow “deficit” grew by more than 35% per year.
So is Netflix making money?
If you define making money as being profitable, then yes.
If you define making money as generating free cash flow, then no.
How do these numbers for revenue, net income and free cash flow relate to each other?
Revenue is certainly a big driver for profitability.
Both have gone up dramatically over the years.
Revenue is also a big driver for free cash flow generation, but it seems that the revenue
growth has not been big enough to turn overall free cash flow positive.
What are the drivers of Netflix revenue?
By far the most important one is the number of paid memberships, which has grown dramatically.
For example, in 2019 versus 2018 an increase of 23%.
Additionally, the average monthly revenue per paying membership (which reflects pricing
as well as mix between various types of membership plans) plays a role.
In 2019 versus 2018, this went up 5%.
Lastly, given that Netflix is operating in over 190 countries,
fluctuating exchange rates can impact revenue.
How does revenue impact profitability and cash flow?
Members are billed in advance of the start of their monthly membership and revenues are
recognized ratably over each monthly membership period.
So for profitability in the income statement,
revenue is recognized through matching month-by-month.
For cash flow, what’s important is that the cash payment is received upfront.
So cash flow from paid memberships gets recognized quicker than income from paid memberships.
The main factor that explains the difference between profitability and cash flow for Netflix
is how streaming content assets,
the TV series and films that Netflix owns or has a license to, are treated.
Let’s zoom into these, as they provide the key to the majority of the costs in the income
statement, and the majority of the cash outflow in the cash flow statement.
Here’s the official description of streaming content assets from the Netflix annual report:
the Company acquires, licenses and produces content, including original programming, in
order to offer members unlimited viewing of TV series and films.
The word “assets” suggests that we should be able to find these on the balance sheet,
as this is something that Netflix owns.
Correct! Content assets make up more than 70% of the value of the total assets on the balance sheet.
$24.5 billion, to be exact.
In the notes to the financial statements, we can even find the split between licensed
content assets worth $14.7 billion, and produced content assets worth $9.8 billion.
Produced content assets are the original Netflix series and films that the company produces.
So if the value of the TV series and films at a point in time is found on the balance
sheet, then how does the in- and outflow work?
The inflow is new TV series and films that Netflix produces or gets a license to.
The outflow consists of the TV series and films being watched by members.
The consumption of the assets.
The inflow of content assets is reflected in the cash flow statement.
The outflow of content assets is reflected in the income statement.
From the Netflix annual report: based on factors including historical and estimated viewing
patterns, we amortize the content assets in “Cost of Revenues”.
Amortization is the accounting process of allocating the cost of intangible assets to
current expense.
In other words, the $24.5 billion of content assets on the balance sheet will eventually
end up in the income statement over the years in which the viewers watch that content.
The matching principle in action once again.
The amortization is on an accelerated basis,
as Netflix typically expects more upfront viewing.
On average, over 90% of a licensed or produced streaming content asset is expected to be
amortized within four years after its month of first availability.
Netflix explicitly states that this amortization requires considerable management judgment.
Let’s fly in the income statement and see where the amortization ends up.
Right here, in “Cost of revenues”, by far the single largest expense line item in
the Netflix income statement.
Amortization is not the only expense in that line, but it does make up the majority.
In short: profitability performance is driven to a large extent by revenue (paid memberships
for unlimited viewing of TV series and films) and accounting for the costs related to that
revenue (the actual and expected watch pattern).
Now that we reviewed the flow of amortization of streaming content assets from the balance
sheet into the income statement, let’s focus on the incoming side (new TV series and films
that Netflix produces or gets a license to), for which we turn to the cash flow statement.
What a company shows by publishing a cash flow statement in an annual report, is how
they got from the cash balance on January 1st (on the previous balance sheet), to the
cash balance on December 31st (the latest balance sheet).
The increase or decrease between the January 1st and December 31st cash balance
is called cash flow.
It consists of three categories: Cash From Operating Activities, Cash From Investing
Activities, and Cash From Financing Activities, or terms with slight variations on that wording.
In the case of Netflix in 2019, the company started the year with $3.8 billion in cash,
had a cash outflow of $2.9 billion in CFOA, a cash outflow of $400 million in CFIA, and
compensated for that by issuing new debt leading to a $4.5 billion cash inflow in CFFA, and
a resulting ending balance of $5 billion in cash at the end of the year.
The first two items, outflows from Cash from Operating Activities, and Cash From Investing
Activities combined make up the $3.3 billion
of negative Free Cash Flow for Netflix in 2019.
These line items are net amounts.
Customer collections of more than $20 billion, and $14 billion in additions to streaming
content assets are the two single most important cash flow drivers in the CFOA line.
In short: free cash flow performance is driven to a large extent by revenue (incoming cash
from paid memberships) and payments for streaming content assets to generate current and future
revenue (new TV series and films).
In the press release of the 2019 results, Netflix management stated that it believed
the peak in the annual Free Cash Flow deficit was reached in 2019.
For 2020, the company expects Free Cash Flow of negative $2.5 billion.
Achieving that is a balancing act between the main Free Cash Flow drivers at Netflix:
on the one hand payments from customers (a cash inflow, growing), on the other hand payments
for new streaming content assets (a cash outflow, growing) and payments for operating expenses
and interest (cash outflow, growing).
The plan for Netflix is to continually improve Free Cash Flow each year and to move slowly
toward Free Cash Flow positive.
Time will tell!
Want to learn more about business, finance, accounting and investing?
Then subscribe to the Finance Storyteller YouTube channel, and start watching the next
video in the recommendations on the screen.
Thank you.