When you’re looking for funding, investors may ask about your Deferred Revenue.
But you may not have this number if you are still using cash-basis accounting. Lots of businesses choose to delay moving to accrual-basis accounting until they have to.
That’s why FirstOfficer.io shows you Prepaid Revenue – an equivalent of Deferred Revenue for subscription businesses.
It’s such an important number that every SaaS owner should know it, so bear with me as I explain a bit of theory on how it all works. If you are in a big hurry, just read the summary at the end.
What is Deferred Revenue?
Deferred Revenue is the revenue that is collected but not earned.
Think about annual subscriptions – you charge for 12 months up front. That’s 11 extra months worth of money that the customer expects to receive service for.
This is how accrual accounting handles that revenue:
If you charge customers $120/year, I’ll divide that by 365 and only book the revenue that you earned in current month.
So if the customer arrived on February 1st, I’d book $9.2 of revenue for February:
$120/365*28 = $9.20
The rest, $110.80, would get booked to Deferred Revenue.
It’s a liability – you’ve got the money, but haven’t done the work to earn it yet.
As months go by and you deliver the service, bit-by-bit that money becomes truly yours. As months have different lengths, more money gets booked in months that have 31 days than in month that has 28 days.
What is Prepaid Revenue then?
Accrual-Basis Revenue and Monthly Recurring Revenue (MRR) are very closely related – the recognition rules are just slightly different.
MRR is designed help us follow changes in performance. That’s why we want to divide the money evenly between months instead of days.
$120/year subscription would get divided by 12, and each month would carry $10 of MRR.
No matter that some months have more days than others – correctly calculated MRR stays the same.
Prepaid Revenue is the total subscription revenue that you’ve collected in advance. So it’s Deferred Revenue, but calculated with MRR recognition rules.
As Deferred Revenue is a GAAP metric (Generally Accepted Accounting Principles), I needed to come up with a new name for the MRR-based version.
What does Deferred Revenue tell us?
If all your customers would leave today and ask their money back for the months they haven’t used, Deferred Revenue is the amount you’d have to pay.
When your Deferred Revenue is high, it tells that you’re selling the annual subscriptions extensively enough.
And when your Deferred Revenue is high, but your bank account is empty, Deferred Revenue shows how much you’re borrowing from the future. Which is perfectly fine as long as you realize that if your annual subscriptions would turn to decline, it might cause you cash-flow problems.
Why do you need to know it?
Deferred Revenue is important for understanding your cash-flow. The bigger it becomes, the more careful you’ll need be in cash-flow planning.
For example, a simple change in strategy that favors monthly subscriptions over annual subscriptions can create cash-flow problems. And what if something goes wrong and a mass of those annual subscribers really ask for a refund?
When your Deferred Revenue is high, it’s a good practice to follow up the annual subscription sales separately.
When you look at the number and feel that you’d have troubles paying it – that’s high enough.
How do I follow up annual subscriptions and Deferred Revenue?
In FirstOfficer, you’ll find the revenue from annual subscriptions in Revenue View.
That’s also the same place where you’ll find the Deferred Revenue, under the name Prepaid Revenue.
Just check every month that the revenue from annual subscriptions stays stable or grows.
If it declines much, don’t leave it as it is – find out why it’s changing. Finding the reasons can be tricky sometimes, but I’ll be happy to help if necessary.
Remember that the annual subscription revenue comes from both new customers and renewals from old customers.
If you are growing at good speed, the revenue from new subscriptions is much bigger than the revenue from renewals – but as your business grows older and if there is a Growth Ceiling ahead, the renewals become gradually more important.
You can also estimate how much revenue you will get from old annual subscription renewals each month.
You can jump to different months just by clicking the charts – so go back 12 months and see how much revenue you got from annual subscriptions 1 year ago. Those people will renew this month.
Multiply that number by your annual subscription MRR Churn Rate to see how much of that revenue you’ll probably lose – and the rest will probably renew. Note: Do NOT use Net Churn Rate for this calculation, it won’t work.
To sum this all up…
Deferred Revenue is the money you’ve collected, but not yet earned. You only need to worry about it when you have annual subscriptions and the number is big enough to be a little scary.
When Deferred Revenue gets high, decline in annual subscriptions can cause havoc to your cash-flow. In that case it’s a good practice to follow up the revenue from annual subscriptions.
If you are on accrual accounting, you’ll get Deferred Revenue and annual subscription revenue straight from your bookkeeping.
If you are on cash accounting, you’ll get them from FirstOfficer. In FirstOfficer the Deferred Revenue is called Prepaid Revenue and you can find it in the Revenue View.