Free cash flow case study: Netflix

What is free cash flow, and why is free cash flow such an important financial metric?

The best way to understand #freecashflow 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!

⏱️TIMESTAMPS⏱️
00:00 Introduction to free cash flow case study
00:48 Revenue, profitability and free cash flow
02:31 Drivers of Netflix revenue
03:12 Revenue impact on profit and free cash flow
03:45 Streaming content assets and free cash flow
05:36 Netflix cost of revenue
07:13 Netflix cash flow statement
08:57 Drivers of free cash flow performance
09:14 Netflix free cash flow forecast

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.

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.

Philip de Vroe (The Finance Storyteller) aims to make accounting, #finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!