Let's say your income is 1100$ each year.
Your profit, according to accounting, would be 900$ for the first year, counting only $200 of the investment, then for the following years you'll see a profit of $700, $500, $300, and $100, as the investments accumulate. Oh no! A downward trend!
The cash flow, however, will simply show $100 profit each year.
Which one is more representative of the growing business with recurring investments?
By year five, you’re generating $1100 of income with $5000 of capital invested (that will require $1000 each year to keep up).
You’re _way_ better off in year one here, so it seems the GAAP approach is actually showing the decline accurately. This isn’t a growing startup, it’s a startup needing more equipment to make the same money each year.
(Imagining a bottom pricing scenario, while keeping a positive cashflow.)
Good point. At year 6 this logic breaks down. (Then again, no longer a 'startup' at that point.) Better hope the replacement equipment is double worth it's money. :)
Should make some spreadsheets with more scenarios.
External perception of business health (5x better service!) unintuitively is masking the the accounting reality here (worsening returns).
(Now look at all these cloud services giving better services and pricing every year, seemingly very healthy...) :)
Just as as microcosm, how many YC backed companies have reached profitability? Only two have gone public - DropBox and PagerDuty.
A commonly used valuation technique (discounted cash flow or DCF) relies on projected free cash flows and adjusting for expected CAPEX.
but does a company have to be "honest" about such depreciations? What if the asset isn't actually losing value at the stated depreciation rate? Then at the end of the depreciation period, the company may still extract the residual value by either selling or continue using the asset. Does that somehow then count as revenue? Or did they just magically managed to tax dodge using a fake depreciation schedule?
Theoretically, the only reason we have depreciation expenses at all instead of just expensing the entire cost at once (cash accounting) is that we decided that accrual accounting was more representative than cash based accounting.
I am not an accountant. I’m an MBA dropout after almost finishing.
We define Adjusted EBITDA as net income (loss), excluding (i) income (loss) from discontinued operations, net of income taxes, (ii) net income (loss) attributable to non-controlling interests, net of tax (iii) provision for (benefit from) income taxes, (iv) income (loss) from equity method investment, net of tax, (v) interest expense, (vi) other income (expense), net, (vii) depreciation and amortization, (viii) stock-based compensation expense, (ix) certain legal, tax, and regulatory reserve changes and settlements, (x) asset impairment/loss on sale of assets, (xi) acquisition and financing related expenses, (xii) restructuring charges and (xiii) other items not indicative of our ongoing operating performance.
There is a reason we have GAAP, to keep crap like WeWork’s “Community Adjusted Ebitda” and Uber from saying that their financials really aren’t as bad as they look if you ignore a dozen expenses.