Buffett is Wrong About Free Cash Flow

In the 2000 Berkshire Hathaway annual report, Warren Buffett stated, “References to EBITDA make us shudder–does management think the tooth fairy pays for capital expenditures?” Additionally,

… full reporting means giving you the information that we would wish you give us if our positions were reversed. What Charlie and I would want under that circumstance would be all the important facts about current operations as well as the CEO’s frank view of the long-term economic characteristics of the business.

2000 Berkshire Hathaway Annual Report

I cannot agree more. If you are a longtime reader of Buffett and Munger, you know their position on EBITDA, which includes this discussion:

As much as I appreciate their emphasis on cash vs. EBITDA, I disagree with Buffett’s definition of free cash flow.

He calls free cash flow operating cash flow less maintenance CapEx. That’s close, yet far from a fuller definition, especially where the business is burdened with excessive debt.

Free Cash Flow

Free cash flow is, well, free. You can do anything you want with it—waste it, invest it, or give it away. That’s because you’ve already made your contractual debt payments and satisfied the IRS and your state’s department of revenue for income taxes.

Accordingly, my definition of free cash flow is as follows:

Operating Cash Flow (OCF): less maintenance CapEx, less contractual debt service, fewer income taxes accrued but not paid (assuming you are an S-corporate or LLC).

Let’s drill through some of these terms:

1. OCF is cash from operations as if you were running your business with a checkbook. We do not subtract long-term investments from OCF, debt payments, or owner distributions.
2. Maintenance CapEx – let’s use an example. Assume you run a trucking company. The fleet you replace every three years is maintenance CapEx. When you increase your fleet by three times, that’s investment CapEx. Maintenance CapEx is ongoing and non-discretionary spending. It’s required. That’s why we subtract it from OCF in arriving at free cash flow. But we’re not done yet.
3. I spend 100% of my time working with business owners with revenues of less than $100 million. Contractual debt payments are not voluntary. They are not discretionary payments. We have to make those payments according to the loan agreement. Those dollars need to be subtracted from OCF too.
4. For private companies, we must also estimate what we’ll owe the IRS and local taxing authorities for income taxes. Like debt service, income taxes are not voluntary, they are required.

Once maintenance CapEx, debt service, and income taxes have been subtracted from OCF, we have a true picture of free cash flow, the dollars we can freely invest or spend at our discretion.

Financial Statement Presentation Matters

If I could snap my fingers, every page one of a financial report would include the following in this video:

Free Cash Flow Maxims

Before I wrap up, let’s address three critical cash flow maxims that can easily be taken for granted:

1. Cash is not king, the business model is. Our business model is about how we find, get, and keep a customer (hopefully for life). If we have a problem with free cash flow, more than likely, the most serious problems are with the business model. Occasionally, I’ll find a CEO who does not want to kill the darling they created for something better. Sometimes we need to because the business model does not yield an adequate and predictable stream of free cash flow.
2. There is a book titled Never Run Out of Cash. It’s a catchy title, but not great advice. The better maxim is to never about run out of cash. With the proper modeling methodology, the CEO should be able to predict serious cash flow deficiencies within three to four months of the shortfall. Don’t play with fire on the preposition, about.
3. Finally, there are two forms of free cash flow – upstream and downstream. Many CFOs and leadership teams spend too much time on downstream free cash flow such as AR, inventory, and AP. That’s good, but your best efforts are always upstream where we find marketing, sales, and pre-operations planning (remember, the business model is king). In this case, think sales velocity (more and faster). Improving upstream free cash flow is where we can make the biggest differences with cash.

EBITDA, You’ve Got to Be Kidding Me

I’ve been a Free Agent CFO™ for more than 20 years, and the only time I bring up EBITDA is in the context of M&A. Even then, we use a pricing model based on cash to determine what we can afford for a business purchase. Sophisticated buyers are doing the same thing in their financial models too.

Yet, I still have about one in ten CEOs using that term. I know the reason, and I’ve written about it before: The EBITDA Conundrum.

There are several reasons that CEOs (and CFOs too) use EBITDA in their daily financial vernacular. The biggest reason is poor financial acumen. Show me a business leader using EBITDA, and you’ll find someone who does not understand cash flow, working capital, or liquidity management.

The HALO effect can impact others. When CEOs hang out with their Vistage, Acumen, or Strategic Coach friends, they’ll hear other CEOs with poor financial acumen using EBITDA. Or they’ll hear an internet influencer using the term. Unless the CEO I’m writing about has strong financial acumen, they will listen to these other people as though they have a halo above their heads … “EBITDA must be a measure I use in my business since these other CEOs use it too.” Sometimes, I hate Vistage meetings. That’s because I have to help a CEO or two with their unlearning process after they have been exposed to this language.

Another reason EBITDA is used is pure laziness. In the video, OCF took me a minute to compute. Free cash flow took less time. EBITDA is a quick calculation. Unfortunately, we can compute the number on the face of a P&L. It’s too easy to create and plaster at the bottom of the P&L. If it helps, I’m lazy too. But as a longtime senior leader of every business I’ve served, understanding cash flow overcomes my laziness in relying on EBITDA.

Sophistication bias is another reason CEOs use EBITDA. People who use EBITDA think they understand it because they subtract two numbers from one another to get the result. Cash flow mechanics and measuring requires a strong grasp of the balance sheet. The best CEOs I know can manage the balance sheet in their sleep. The CEO who is P&L-centric doesn’t get cash flow. They only see the cash in the bank–too much or not enough. Sophistication bias kicks in. “I don’t understand OCF or free cash flow, so I’m using EBITDA instead.” They don’t say that, but that’s the behavior leading to the use of EBITDA.

The purpose of this discussion was to point out that Buffett is wrong in the definition of free cash flow. I couldn’t finish the article without addressing EBITDA. Accordingly, I’m comparing a company’s EBITDA and its Free Cash Flow. Here are the numbers for Bed Bath & Beyond per their 2021 annual report:

EBITDA: $131 million
Free Cash Flow: ($373 million)

Free cash flow is negative while EBITDA is painting a positive picture (although the trend downward toward bankruptcy is significant). There’s a $504 million difference between the two. If you are running the business, which number do you need at your fingertips at all times? Go back to the video if you need to which shows how I like to see free cash flow reported.

By the way, there’s a final reason some business leaders shy away from free cash flow in favor of EBITDA. When times are bad, EBITDA numbers nearly always look better than free cash flow. Free cash flow can be scary, but only if the business model is flawed.