Imagine you're a growing startup, and you have a yearly recurring investment (you're growing, after all!) of $1000 that's linearly depreciated over 5 years.
Let's say your income is 1100$ 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?
In year one, you’re generating $1100 of income with $1000 of capital invested (that will last 5 years).
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.
You're right, growing capital but not growing income... I made a poor example.
(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.
Amusingly, assuming the example company's pricing remained the same throughout rather than cutting prices each year, the client base ends up fixed, the clients get 5x better service by the 5th year, while accounting shows a decline in performance.
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...) :)
That’s exactly the story that YC darling DropBox has been telling over the last decade. They still aren’t profitable and according to their own disclosures, have no idea when they will become profitable.
Just as as microcosm, how many YC backed companies have reached profitability? Only two have gone public - DropBox and PagerDuty.
I'm not sure that I understand your scenario. If you actually need to replace the equipment after 5 years, the accounting approach seems like the most valid approach.
For my understanding, do you mean that cash flow would show $100 profit each year on the 5th year, whereas in the first year it would show $900 profit? Thanks.
Let's say your income is 1100$ 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?