Free Cash Flow - A Deep Dive

Live from Schenectady, New York, it's SaaS Talk with the Metrics Brothers, Growth and CAC.

And I'm Growth, better known as Ray Reich, the founder and CEO of Benchmarkit.

And I'm CAC, better known as Dave Kellogg, independent consultant, EIR at Balderton Capital, and the author of Kellogg.

And together we are the Metrix Brothers.

And we go together like red beans and rice. Ray, have I done this one before?

You have not, but you're back to food again, Dave.

I do. I love red beans and rice. And look, next week, if you're tired of food, you could do the analogy.

So are you going to New Orleans? Have you been there lately?

No, no, no.

Red beans and rice is just one of my favorite dishes to make in the old Instant Pot.

Instant Pot. Now that's a category reinvention story.

It sure is. For years I was afraid to use a pressure cooker until the Instant Pot came along, right? Because you could blow it up. But as I also remember, Mr. Growth by Expansion over there, uh, that it's actually a phenomenal case study in both reinventing a category and then, then having no expansion potential. Like there was no adjacent category they expand to. I think they tried a bunch.

Okay, wait for this one, Dave. That's interesting, but what's cooking for today?

Ouch. So what's cooking for today, Ray, is free cash flow. You know, oftentimes a lot of my favorite episodes, Ray, are we focus an episode on a single metric. Um, so that's what I'd like to do today, and I'd like that metric to be free cash flow.

Okay, free cash flow it is. But before diving in, let's hear a word from our sponsor. The Metrics Brothers is proudly sponsored by Benchmarket, The B2B AI and software industry's largest, broadest, and most contextualized benchmarking index. Dave Kellogg and Ray Groth Wright have put the Metrics Brothers podcast on hiatus for the remainder of 2026. All episodes we have ever recorded are still available on your favorite podcasting app. You can reach Dave at Kellogg and Ray on LinkedIn at Ray Reich. Thank you so much for listening to the Metrics Brothers podcast. Okay, Dave. So I have to admit here, this is where me not being a CFO limits a little bit of my depth of my knowledge about free cash flow. So why don't you highlight the episode and what we're going to talk about today?

Well, 2 things here, Ray. As you know, I'm not a CFO either, but I am an MBA. And this is going back to my business school in the 1990s. We'll be touching on some topics here from my initial kind of finance and accounting classes. But, but before we jump in, right, we're going to talk about free cash flow and what it means and why people like it. But before we do that, I just want to ask you a question. And I know this is a trick question because there's actually 2 Rays, and maybe you can answer it from both perspectives. There's Ray the GE guy, and there's Ray the SaaS Metrics guy. And let me ask both Rays, answer in either order, why do you care about free cash flow?

Well, the foundation of my corporate experience with GE, so I have to say it's because Jack Welch told me that cash flow was one of the top 3 measures of running a company. So, that's number one. But now, number 2 is, you know, I talk about metrics all day, you know, co-founded the SaaS Metrics Standards Board. So, one of the most important metrics, the Rule of 40, includes 2 variables. It's your growth rate plus free cash flow margin. So if you believe the Rule of 40, which by the way, Dave, news break here, as of last week, Rule of 40 now has the highest R-squared or correlation to enterprise value, even higher than growth. So that's why it's important.

Interesting. So I always view that as kind of what time— what kind of times we're in. When Rule of 40 is a better predictor of enterprise valuation than growth, we're in conservative times. when it's the worst predictor of enterprise valuation, we're in aggressive times. But that's interesting. You said a lot there. Let me unpack some of it. Because one thing I actually disagree with, you defined FCF into Rule of 40, which I think is actually slightly too precise. I think Rule of 40 is generally accepted as some growth metric plus some profit metric, right? Everyone can agree on that. And that's where the universal agreement ends, unfortunately, right? They all agree that 40 is the target. that it's supposed to be a metric that balances things. And what we're going to balance specifically is growth and profit. So let's add some growth metric to some profit metric. Now you pick free cash flow margin as a profit metric, which most people do today. Some people pick EBITDA margin, some people pick operating margin, right? Net income margin. There certainly are other choices, but, but I think we both agree that free cash flow margin is kind of winning the day as the R40 profit metric. But the R/40 growth metric, which we won't do in real detail here, is also up for debate. You know, a lot of small private companies use ARR growth. Big public companies, we don't know what ARR is. So we're doing it either off implied ARR or we're doing it off revenue growth. So, but the thing we can all agree on is that Rule of 40 balances growth and profit. And I think probably the most standardized choice of all those choices is free cash flow margin as the profit metric.

Totally agree. It is what the SAS Metric Standards Board defined as the Rule of 40 score and includes free cash flow margin as the profit variable. But before we get into the Rule of 40, which I could talk about all day, or not before, instead of, why is free cash flow so important?

Yeah, so look, so the origin of this episode, by the way, to me, Ray, it was I wanted to do a post on what should be the right profit metric in Rule of 40. So it got me focused on free cash flow. But when I start thinking about free cash flow, other things come to mind, like the 1980s and 1990s, the corporate raiders, LBOs, 'cause they talked a lot about cash flow, right? The narrative at the time was, oh, just looking at the income statement didn't show real value and we could unlock value by looking at cash flow. So this kind of overtone of, hey, the rest of the world is looking at the wrong metric. And if you look at the right metric, cash flow, that then you can go unlock value. So I've always had this ooh kind of thing about cash. Like somehow it's more magic. It's actually quite simple. But somehow it gets, you know, pitched as this magical thing. The other thing I'd say about cash, Ray, and you said this with the Jack Welch quote, I'll give you the full quote, which is Jack Welch said, if I had to run a company on 3 metrics, those metrics would be customer satisfaction, employee satisfaction, and cash flow. It's actually a pretty interesting quote. Uh, I know Jack Welch's reputation has suffered over the years, uh, but, but think about that. I want to know how happy my employees are. I want to know how happy my customers are, and I want to know if I'm generating cash, basically. Um, it's a great metric. Uh, another favorite quote on cash flow— I mean, basically, this is the argument why cash matters so much to business. Richard Branson: Never take your eyes off the cash flow because it's the lifeblood of business. My personal favorite quote from Don Valentine, founder of Sequoia: All companies go out of business for the same reason, comma, they run out of cash. There's a Peter Drucker quote on it as well. But, but one of the more interesting quotes I found, Ray, was from Michael Dell. who actually talked about how he got Dell into trouble because, quote, we were always focused on our profit and loss statement, but cash flow was not a regularly discussed topic. It was as if we were driving along watching only the speedometer when in fact we were running out of gas, right? What a great quote, because, because cash is oxygen, is gas to a startup. Any thoughts on those, Ray, before I do my last quote?

Well, do you mind if I share a quote?

Please.

Because you talked about operating profit variables that you can use, um, and you mentioned the word EBITDA, and it just reminds me of one of my favorite investors, and that is Charlie Munger. And you know what he said about EBITDA? He goes, anytime you hear EBITDA, you might as well just replace that word with bullshit because it's not a true measurement of a company's financial performance.

Yeah, we'll touch on that. I know you like that quote. I know you like, uh, Munger and Buffett. We'll touch on that a little bit indirectly because EBITDA, for example, excludes capital expenditures, right? Because it excludes depreciation and amortization. So it excludes the ongoing cost of capital expenditures. And I think Warren Buffett's quote was, who do you think pays for capital expenditures, the tooth fairy? Or he had some quote along those lines on like, hey, if you're going to need to build factories to make shoes, you can't exclude the cost of the factories to the business, right? I mean, I guess you can until the factory breaks and then you're done, right? So you have to include that. So we'll touch on that because free cash flow does include capital expenditures, unlike EBITDA, which is— which at least excludes the depreciation and amortization associated with them. My favorite quote finally on cash, though, is cash is a fact, profit is an opinion. And this is subtle. Like if you've not gone to accounting class, you may think accounting is— no, no, accounting is super precise, right? There's lots of rules. It can't be an opinion. But, but the fact of the matter is there's a lot more opinion in, in profit, right, in a GAAP P&L than you might think. And cash really is a fact. I mean, metaphorically, I could call up your bank and ask the checking account balance, and, and that's your cash balance, right? So cash is a fact, profit is an opinion. Any more thoughts on that, Ray, before we drive— dive in?

No, cash is a fact, but free cash flow, I won't say it is an opinion because it's a formula, but there's multiple formulas. So can we Talk about what is free cash flow.

Yeah, so look, there's 2, define it for you conceptually, then practically. But I need to start by elaborating on this concept of accrual accounting, which is one of the reasons cash is a fact and profit is an opinion, because opinions kind of get entered into the mix when we do accrual accounting, i.e., when we make a profit and loss statement and we produce a number like net income at the bottom of it. And the idea is that accrual accounting is trying very hard to make an accurate picture of reality. I wanna go back to my factory. But one of the ways they try and create that accurate picture is by what they call the matching principle. We do match the timing of revenues and expenses. It sounds like a really good idea. In fact, for example, if we spent $900 million to build a factory that's going to last us 30 years to build shoes, well then 2 things happen, right? One, I did pay someone $900 million to build that factory. Just pretend I had a ton of cash in the bank. My cash balance is now down by $900 million to build that factory. That is a fact. But, but I also now own this factory that's going to serve me in theory for the next 30 years. So what accrual accounting does is say, hey, wait a minute, let's match the expenses and the revenues. And that factory is going to generate revenue. It's going to make shoes for 30 years. You're going to sell shoes for 30 years. You know, 29 years from now, you're going to sell a pair of shoes that was— whose cost was incurred today when you built that factory. So we're going to do the matching principle and we're going to amortize that cost. We're not going to take on your profit and loss statement $900 million in one lump. We will on your cash flow statement because $900 million cash went out. But in your profit and loss statement, we're going to charge that at $30 million a year. Right. And it's just— this is what creates the problem. I'll give you other examples that are closer to SaaS, but the whole problem is created through kind of good intent on GAAP, generally accepted accounting principles part, because it's trying to do things like matching.

Right.

And if you're going to match the cost of the factory, you need to match it with its lifetime and how long it's making shoes, right? And this, however, confuses what I might call purity. And these are words I picked arbitrarily, but, but okay, so, so it's accurate. We're trying to really reflect the reality of the business, but, but somehow it's not pure in my mind, which is I did just spend $900 million and that gets kind of lost on the P&L. Whereas if I look at the bank balance, you'll see it's gone. And happily, if you look at the statement of cash flows, you'll see it's gone. So we could use an example closer to SaaS of this, right? Do you want to do it or you want me to do it? I think we should talk about accelerated commissions.

Yeah, no, I think it's really important. And why don't I take a shot at it? Because as we do all these SaaS metrics calculations, this is one of the more common questions because with ASC 606, on ASC 606, we're being required to capitalize Sales commissions. So, let's say someone sells a really big deal and we had to pay a rep $300,000 in commissions, right?

Big deal.

Which is a prepaid expense.

Yeah.

Let's say that deal is a 3-year deal. So, using your matching principle, that says we should amortize 1/3 of that commission or $100,000 a month. So, the $100,000 impact per year Using your nomenclature is an opinion. But the fact is, I look at my bank balance or I look at my sales rep's bank balance, but I look at my bank balance and I've got $300,000 less. That's a fact. Is that kind of a good example?

Yeah, that's what I'm saying. And people could debate whether it's an opinion, but, but this is what it's— it's what the quote means, right? The quote's a little bit tongue in cheek. There are rules, and Ray cited the specific rule ASC 606 that requires you to amortize that commission expense in line with the duration of the contract. So you could argue it's kind of a fact because it's driven by rules. But in another sense, a person made the rules, and that's where it's kind of an opinion that some guy somewhere decided we amortize computers over 3 years, factories over 30, airplanes over 10, you know, whatever, and that's what's gonna show up on our P&L.

Hey, Dave, I remember, you know, when I started in enterprise software, kind of like you, I remember when we actually would capitalize the R&D for software development. Do you wanna talk a little bit about how that plays into today's reality?

Well, people still do that, as I'm sure you're aware, Ray, I hope.

People still do that today, right?

And the idea of capitalizing R&D is a little bit back to that factory, which is I'm building something that's gonna have a useful lifetime. And then technically, you know, expensing is if I pay someone's salary to work for me for a day, it's gone. They've done whatever work they did, and at the end of the day, that money's gone. But if I'm building a factory, then I have something I'm gonna own for 30 years. Well, when you're building a product, there is a question of, now wait a minute, this thing, this R&D expense technically shouldn't be expensed. Because it's not just gone, right? Like DevOps expense or TechOps expense might be expensed because it was gone. You paid the team, they ran the app for another day, they paid Amazon the bill for the cloud computing, you're done, right? That gets expensed. But R&D, maybe it should be capitalized. And a lot of companies do this. Again, there are specific rules on how to do it, but it's another example of where the matching principle creates a gap— lowercase g and only one a— A gap between What you'll see in the bank balance, which is I still paid all the developers their $250,000 a year salary, right, for that time period— that's gone. That's a fact. Cash is gone. But it will show up as less than that in the P&L because I'm allowed to capitalize some of that and say, hey, I'm building a product, it's got a useful lifetime, so I'm going to kind of treat it as if I bought a factory and amortize that over 3 years. So, so it's the same thing, right? It's the same thing, uh, basically capitalizing commissions Capitalizing R&D, all the same thing.

Cool. But there's some other ways to kind of look at free cash flow or describe it. So can you share a little bit more details on those?

Yeah, another way to look at this metric, Ray, is we're just trying to look— I mean, I always like starting at the top that you did, but just how much cash is left over to do things, right? Like to invest in our other R&D initiatives, to pay back debt, right? To, uh, to distribute as dividends, right? When I'm kind of done running the business which in this definition of running the business includes capital expenditures, building factories, for example. When I'm done with that, how much money is left over? So I like that definition of free cash flow. Part of that, if you're going to look at the statement of P&L and kind of unwind certain things they've done, we talked about kind of backing out amortized commissions. We talked about backing out amortized R&D. The commissions one being the simplest. Oh, it only shows up as $100K of expense for year 1, but in reality we spent $300K on that rep. So from a cash perspective, that expense was $300K. $100K. From a GAAP perspective, it was $100K, right? Well, there's another form of this that's more elusive, which is stock-based compensation. And in that case, there's no cash at all. Like, like, they— when I give you a stock option as part of your compensation package that you might exercise 5 years from now, and you're going to pay me $10 a share for it, and those shares 5 years from now might be worth $100 a share, there's no cash impact until 5 years from now. The only actual cash impact is at year 5 when you exercise them I'm going to sell you shares for $10 each that I could have sold on the open market for $100. So there's kind of a $90 opportunity cost. But, but in fact, when you exercise, it actually shows up as a cash flow positive event for the business, right? Because you're giving me $10 a share. It turns out it's a shitty price for me to sell at, but nevertheless, I'm receiving $10 a share times the number of shares as cash coming into the business. So for these reasons, and because this can be a material expense in software companies because they give a lot of stock options out, and RSUs. Um, you have this thing called stock-based compensation, which is another quote-unquote non-cash expense. Um, and this generic process we're describing is kind of backing out non-cash expenses. And stock-based comp is another one. And it's— it is— and there's formulas for how to calculate its impact. But, but let's be clear, it is an operating expense. So, i.e., it's in the same line as sales. When you have a line in your P&L for sales, this could include salaries, commissions, and stock-based comp. So when I look at your sales expense as a percent of revenue, it's going to include by default stock-based comp unless I back it out. And once again, in this kind of analysis, what we're trying to do— because we're trying to look at cash, think the bank balance— I don't want to look at that at all, right? Like, that's just pure noise from a cash perspective because we're trying to look at cash.

You know, Dave, I can't believe it. We're already almost 18 minutes in this episode and we haven't got into What's the preferred calculation formula you like to calculate free cash flow?

Yeah, got it. So hopefully we've motivated the reason why people care about it. But, but ultimately, look, I'll get to the formula in one second. We care about how the cash balance is changing. We care about how much cash the business can generate. So free cash flow, defined conceptually, is the money a company has left over after paying its operating expenses and capital expenditures. I.e., what it needs to do to kind of run the business. When you view CapEx as part of running the business, there's a lot of different ways to calculate it. It can get very complicated. And if you do this backing out process, personally, I find that more complicated. That's called the indirect method. If you go back to business school, you start with net income and you start taking things out of it or adding things back to it, right? So let's, let's add back, or in this particular case, if we're trying to get to cash, let's add in that $200 that we paid the guy that didn't show up in the P&L. I need to include that.

Right.

So that's the indirect method. The direct method is super, super simple, which is cash flow from operations minus capital expenditure. Now, to understand what that means, we need to go back to B-School for a 1-minute reminder that there is a— one of the 4 financial statements of any company is called the cash flow statement. The cash flow statement has 3 sections: cash flow from operating activities, cash flow from investing activities, number 2, and cash flow from financing activities, number 3. So operating activities are those kind of just running the business, operating it day to day, paying salaries, buying materials, paying health insurance, etc. Those are all operating activities. Investing activities really come into 2 types. One, capital expenditures, typically property, plant, and equipment, like buying a factory, or in our case here in a SaaS company, it might be capitalized R&D, it might be kind of prepaid commissions. Financing activities, because I'm not actually sure if they're capitalized or just a prepaid expense on the balance sheet, but we'll come back to it. We'll say capitalized R&D. Definitely qualifies as a capital expenditure. Financial investments are also investing activities. So if you buy a bunch of securities, you buy a bunch of long-term government bonds, that would end up as a financing— that would be a negative cash flow when you buy them and a positive cash flow when you get them, but a cash flow from investing activities. The last is financing activities, which for a startup is typically selling stock, i.e., raising a round, selling equity. For a public company, it might be buying stock back. So negative cash flow for buying your own stock back. And then taking debt. So if you take a $10 million loan, then you get $10 million in positive cash flow from financing activities. So to understand what free cash flow is, you just need to understand the statement of cash flows, these 3 sections, and then just say, what's cash flow from operations minus capital expenditure? Et voilà, you have free cash flow.

Okay, you asked me a question early on, kind of, you know, why am I interested in free cash flow? Let me ask you a question. Why do investors like it so much?

So look, there's a couple reasons here, Ray. One, I think first this idea that it's the money left over to pay for other things. Um, and the question might— what people— what are other things? And one might be to, you know, pay down debt, pay dividends, invest in growth opportunities. But specifically for like a private equity investor, if you're thinking of buying a company, pay debt is a big one. Because if I'm going to buy a company and put a lot of debt on it, as they often do, Like, let's put 2x ARR debt on a— let's buy a $50 million company for $300 million, and I'm going to put $100 million in debt on it, 2x ARR. And that way, I only need to come up with $200 million cash to buy it. Well, I got to make sure this company has a cash flow such that it's able to support paying back that debt. So free cash flow is a great metric to look at and say, okay, what's the free cash flow on this thing? Are they going to have enough money to pay the debt? Reason number 1. Reason number 2, and this one I forgot until I started doing the homework for this episode, But most stock valuation models, if you look at any public company financial research, in the end there's always a discounted cash flow analysis. And discounted cash flow analysis are based on cash. I remember when I went to business school and I first did capital budgeting, I was shocked that everything was based on cash, not based on GAAP numbers. And like, no, no, no, no, capital budgeting is done on cash. Well, so is discounted cash flow analysis for public company stocks. So basically public company analysts need to use cash flow to build a DCF.

Right.

So they want to focus on cash, not on GAAP profit. And the last reason is, as you mentioned earlier, from a metrics point of view, free cash flow has basically become the standard profit measure in the Rule of 40.

Okay. So I think we need to summarize it and I think you can take us home. Can you just talk about why you believe free cash flow is an important metric or why it is?

Sure. So, so let's wrap this up. I agree. First, let me just say there's a couple of ways of calculating it. And the real rat hole here is getting too much into that, which is why I like our simple formula, which is cash flow from operations minus capital expenditure. The indirect method, it teaches you more about how it works, but it takes some time and can be confusing. So that's what it is. It's easy to get off the statement of cash flows if you have one. We can use it in the Rule of 40. And by the way, this begs— maybe we'll need to do another episode, Ray, on EBITDA, but the difference between free cash flow and EBITDA, because they're both kind of trying to do the same thing, right? Let's look how profitable the business is after we exclude certain things. For EBITDA, we're excluding interest, taxes, depreciation, and amortization. For free cash flow, well, we're excluding all investing activities and— no, but capital expenditures, and we're excluding all financing activities. Whereas for EBITDA, we're just excluding those that basically the BITDA or the ITDA are getting excluded. So we could touch on that, but at the end of the day, it's a super important metric, and hopefully we shed some light on it.

And it brought a lot of details into why one of the favorite sayings of investors is cash is king.

There you go, Ray. Take care.

Okay, thank you, Dave.

The Metrics Brothers AI, SaaS, and More is a production of the Metrics Brothers Growth and CAC and a member of the Benchmarkit Podcast Network. By accessing this podcast, you acknowledge that the Metrics Brothers make no warranty, guarantee, or representation as to the accuracy or sufficiency of the information provided Or the humor content of the jokes told.

Ahem.

Ray. Information, opinions, and recommendations presented are, according to our spouses, probably wrong and provided for information purposes only. This podcast should not be considered professional or, for that matter, unprofessional advice. We disclaim any and all liability for any direct, indirect, indirect, misdirect, incidental, special, ordinary, consequential, inconsequential, or other damages arising out of any use of, or God help you, reliance upon the information presented here. Ray Grothreich is based in New York City and available on X @rayreich. Dave Kellogg is based in Silicon Valley and available on X @kellogg. Schedectady, which is French for unspellable, is not our actual production location. Thanks for listening.