Thread by @AliTheCFO

In a 2004 investor letter, Jeff Bezos said:

“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

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:

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

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

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

If you’d like to learn more, I’ve covered the difference between “profit” and “cash flow” in a previous thread:

https://twitter.com/AliTheCFO/status/1455515035485151241?s=20&t=Kn7sEV-HI2_-UwfVNPLIkw

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

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.

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

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

8/ Amazon

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?

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

Therefore, you can conclude that in the case of amazon,

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

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