3 Financial Metrics That Can Help You Better Understand Software Businesses

GAAP (generally accepted accounting principles) numbers tend to capture quarterly earnings reports headlines, and for good reason. However, basic financials don't always tell the whole story, especially for software companies. In this video segment from Motley Fool Live's  "The 5" recorded Sept. 30, Fool contributors Brian Withers, Toby Bordelon, and Nicholas Rossolillo discuss three non-GAAP financial metrics that can aid in understanding a software business.

Brian Withers: Cisco (CSCO -0.52%), this is interesting sometimes the press goes a little overboard, but Cisco introduces new metrics to showcase their shift toward software. You read the article and it says they're going to start reporting annual recurring revenue and subscriptions as a percentage of total revenue. [laughs] It's not groundbreaking by any stretch to the imagination, but kudos to Cisco trying to adapt. These are actually non-GAP metrics but they do give you some understanding of how subscription business is running. I wanted to talk a little bit of metrics today. What is one GAAP metric and one non-GAAP metric you like and why? Toby? You're up first.

Toby Bordelon: You know what I'm going to say. You know what I love. Cash flow.

Withers: Stock based compensation.

Bordelon: We're going to get to that. We're going to get to that actually. I like operating cash flow, specific the operating cash. This is a GAAP metric. There are rules on how you calculate that and you see in the cash flow statement, it's right there, plain as day. You don't have to work hard to see what is the operating cash flow. You can play with earnings a little bit. Legitimately. I'm not saying anything untoward, but when you're looking at earnings, when you're calculating earnings, a lot of that comes from when is revenue recognized. There is a lot of, I don't necessary want to say guess work, but that's true to some extent that goes into that. What is your trigger going to be? How are you going to say when a contract is 80 percent completed versus 70 percent completed? How do you just figure out what number you're going to put on there?

There's some give-and-take on earnings, but cash, you have your cash balance at the beginning of the period. You have at the end, it's night and day as long as you're keeping your books properly. That's a very hard number. What you actually collected, is the cash you actually brought in versus the revenue that you earned based on whatever accounting rules and the adjustments you're going with. If you're trying to grow your business, if you're trying to run your business, if you're trying to pay your bills, pay your employees you do that with cash. You can't do that with earnings, it's got to be cash.

When I look at operating cash flow and when we have the operating version because it tells me whether the company is making money to fund their actual business. They're operating part of their business, and whether they can sustain both their expenses and their growth. Their operating expenses and their growth expenses from the cash they generate. If you see positive operating cash flow, ignoring for the moment financing cash flow and investing cash flow, that's a very good indication that the business is self-sustaining, that they can fund themselves out of operations and that is fantastic. You don't have to rely on external financing to do what you need to do. You love to see that.

For the non-GAAP side of things, I would say I use an adjusted version of those operating earnings or I like to, you can pull out some things that might be propping up cash flow, but are still very real business expenses that you might not want to factor in that calculates for whatever reason. Maybe if there is actually a version of free cash flow, but maybe I calculate a little bit different than some people do. But one key item we're talking about there is stock-based comp, Brian, as you alluded to. 

Withers: It's Toby's operational cash flow.

Bordelon: It's my version of operating cash. Here here's my justification for it. Yes, stock-based comp is absolutely a non-cash expense for sure and the employees know that because they're getting stock, not cash. But it takes value from shareholders. You're diluting shareholder value in order to preserve cash. When you really think about what's going on functionally, I think you could logically put stock-based comp into financing cash flow instead of operating cash flow. Because what's your functionally doing is financing your business by selling stock to your employees. They are taking that stock in-lieu of the salary that you would give them. They're taking that as part of their salaries so that's really what you're doing. Getting financing from your employees and from their labor.

I think it really more logically to me, belongs in financing cash flow but GAAP tells us it's part of operating cash flows so there you go. The other reason I like to take it out is because you can do a thought experiment. You can say, "All right, let's pretend I wasn't a public company. Let's pretend I was private, let's pretend I was 100 percent owned by someone else." What does that business look like then? Well, without publicly traded stock, without any kind of stock at all, you're going to have to pay those employees in cash. That non-cash numbers suddenly becomes a cash number. All things equal.

If that's your scenario, if you weren't public, you didn't have a public markets to help you out, could you still run this business sustainably? If the only reason you are operating cash flow positive because you're paying a lot of compensation and stock, my suggestion is no, you can't. Not sustainably for the long term, you're going to need something else.

That's just one thing I'd like to do, is to take the operating cash flow and say let's take a step back and see whether this is actually making money from an overall business standpoint. Sometimes it's still is. Sometimes you can see coming with what's really big non-cash stock-based comp numbers and still how positive operating cash flow, then you want to say, "Okay, good on you." Those subscription businesses that we've done a lot of deep dives on are good examples of that because they bring in a lot of massive cash upfront that is not immediately credited to revenue, it becomes differed revenue. They have the cash on hand and they can use it to grow. They can use it to operate their business and I love those companies.

Withers: Yes. Toby, when you were explaining your non-GAAP metric and whether companies can actually afford their stock-based compensation. Reminds me, Suze Orman used to have a show, and people will come on and go, "Can I afford it?" I could see this young upstart CEO going on the Suze Orman show, I want to pay my employee stock-based compensation. [laughs] Suze Orman grill him about whether he could actually afford it or not and what's his cash flow and all at.

Bordelon: To be fair, using stock-based comp is totally legitimate and it's the way things are done in Silicon Valley and a lot of employees want that. It allows employees to become owners of the business and to participate in that upside from a high-growth business. It's not like I'm saying, I would never want to see that. I just think that when you do see it, especially if it's a large number, pull it out and see what it looks like without that and you get a better sense of what the operations are doing. I do like having employee-owners. I think that's awesome. I just wish it wasn't thrown into operating cash flow.

Withers: Excellent, excellent. Nick, what metrics do you like?

Nicholas Rossolillo: I'm with Toby. I love the free cash flow metric related to operating cash flow. I love it though because it only factors for the actual operating profit. It excludes all the non-cash stuff. But you also get a good picture of capital expenditures like property, plant, equipment that a company is spending on. It can be lumpy sometimes like it's up and down a lot, but it's real profit for the business. I love that one.

But it was interesting, Cisco said it's going to start reporting this ARR, Annualized Recurring Revenue. I think that's a really interesting non-GAAP metric to keep tabs on. There's a lot of companies besides Cisco that are reporting that now and specifically like some of these legacy tech companies. They're now suddenly a little bit behind the curve, they're trying to make their own transition to Cloud along with every other business out there in the economy. As they do so, that ARR figure can be really helpful in determining if the company is really growing or not.

A couple of weeks ago, I talked with Jason about Splunk (SPLK), it's in a similar boat. If you're only looking at revenue and a company is transitioning to like a subscription business or a Cloud business, they can give this effect that the company is suddenly shrinking in size. But it's like the whole term revenue that they collect and realized upfront that phases out and then the new contract with the customer becomes a cloud-based one where you can collect the revenue, but you can't record it as revenue until you deliver the service.

ARR takes both the term and how revenue on an annualized basis, combines it together, and it gives you like a more true sense of what the actual revenue trajectory is for the business. I think that's a great one to keep an eye on for companies that are undergoing a similar migration like Cisco is.

Withers: Yeah. There's actually quite a few companies that are doing that. I know Alteryx (AYX) is one, Atlassian (TEAM -7.11%), just to name two stocks that began with A, that use ARR. [laughs] Great, let me wrap up. To be boring, top-line revenue growth, love it. The bigger than number, the better.

The other piece is where that revenue is coming from. If you're a company like iRobot (IRBT -3.50%), you have to sell a certain number of robot vacuum cleaners every quarter. Once you sold one, that revenue disappears and you have to go earn that revenue again. I very much like companies that have a steady stream of revenue coming in, either subscriptions or a lot of times, things like e-commerce, isn't necessarily recurring revenue but once you get people hooked, they're buying things from you again and again and so you get that repeat factor and it's not like you're buying a vacuum cleaner every month. You're buying different things. Revenue growth is one of my favorite.

From a non-GAAP perspective, remaining performance obligations. This is one that's around software and any companies that have contracts. Remaining performance obligations basically is, if I have a 12-month contract and I've already completed two months of that, 10 months of the value of that 12-month contract is remaining performance obligations. I may have been paid upfront for it, or I may not have not. The cash flows is completely different, but this is just what customers are on the hook to you for. I love it when that number grows because then customers are signing longer or larger contracts and that just says that there's more growth to come as the company gets into those larger and longer contracts. Those are the two metrics that I like.