- GAAP revenue recognition can be misleading and create opportunities for investors.
- Multiparty transactions and changes in performance criteria can distort net revenue numbers.
- GAAP revenue doesn’t differentiate between pulling forward future revenue and slowing customer demand.
- The cash conversion cycle should be measured as a percentage and include deferred revenue.
- Excluding deferred revenue from the CCC can lead to misvaluing businesses and missing the SaaS death spiral.
- “Free cash flow” is an accrual metric and may not accurately represent the cash generated by a business.
- Investors need to consider normalized FCF and be aware of accrued assumptions.
- Recharacterizing the balance sheet can provide further insights for investment decisions.
Companies are often judged by flawed accounting standards, and understanding those flaws can generate alpha for investors. This article explores the relationships between revenue recognition, the cash conversion cycle, and free cash flow, and highlights areas where opportunities may arise for astute investors.
“Revenue” isn’t revenue, it’s contract timing
Revenue is recognized when a contract between a business and a customer has been performed. GAAP revenue recognition can be problematic in several ways, including multiparty transactions where revenue can be distorted, changes in performance criteria that affect reported revenue, and the inability to distinguish between temporarily pulled forward contracts and increasing customer demand.
The cash conversion cycle should be measured as a percentage and include deferred revenue
The cash conversion cycle (CCC) measures how long each dollar of working capital is invested in the production and sales process. The CCC should be measured as a percentage to provide a more accurate representation of capital efficiency. Additionally, including deferred revenue in the CCC allows for the identification of capital-light businesses and the detection of potential issues such as the SaaS death spiral.
“Free cash flow” isn’t free cash flow, it’s an accrual metric
“Free cash flow” doesn’t always correspond to the actual cash generated by a business. This poses a challenge for investors who rely on discounted cash flow (DCF) analysis. The calculation of free cash flow involves accruals, and determining normalized free cash flow requires considering factors such as internally-developed intangible assets and hidden capital expenditures.
Moving to the Balance Sheet
Recharacterizing the balance sheet can provide further insights for investment decisions, including revisiting the weighted average cost of capital, market value of equity, and share-based compensation.
Overall, understanding the flaws in accounting standards and considering alternative perspectives can help investors uncover opportunities and make more informed investment decisions.
