# How does deferred revenue work?



## CBerg (22 October 2018)

In the vein of starting more stock related discussions, I asked this on the VLT thread but never got an answer.

How does the accounting work for "deferred revenue"? I get it's revenue for coming quarters but what's the other side of it in double entry?


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## luutzu (22 October 2018)

CBerg said:


> In the vein of starting more stock related discussions, I asked this on the VLT thread but never got an answer.
> 
> How does the accounting work for "deferred revenue"? I get it's revenue for coming quarters but what's the other side of it in double entry?




Good question. 

https://www.accountingtools.com/articles/what-is-deferred-revenue.html


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## CBerg (22 October 2018)

Oh yeah the bank account! Damn simple yet couldn't quite figure it thanks @luutzu

So if a company has more deferred revenue then their cash is that typically a bad sign or really in the scheme of things not a big deal?


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## luutzu (22 October 2018)

CBerg said:


> Oh yeah the bank account! Damn simple yet couldn't quite figure it thanks @luutzu
> 
> So if a company has more deferred revenue then their cash is that typically a bad sign or really in the scheme of things not a big deal?




Probably a bad thing. All else being equal. It depends 

Say ACo got paid a deposit for $10M for work to be done in 6 months time. The $10M should sit in its bank account, set aside earning interest and nothing else. ie. it's ready to be paid out/expensed when the work commences.

So ideally the cash should be set aside so that when work start, there's cash to pay people. 

But depends on the nature of the work, the industry, profit margin... depends on where that deferred revenue is gone to. Short term gov't bond? Into the hands of able investment managers who will, with their genius, caution and the company's large current financial/marketable assets... cash at the bank is not the best use of free cash. 

But if the cash goes towards other projects that's losing money, being delayed... more borrowings or cap raising might be required?

I guess Graham's advice for a margin of safety is needed. 

That's just my interpretation. I'm no CPA.


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## CBerg (23 October 2018)

The sector I’ve been looking into is IT so some of the revenue is probably software licensing and some probably upfront payments for projects.

I guess the interesting thing to me is if there’s enough unearned revenue there’s the potential that they’re getting their/part of their working capital for free provided it’s being used in a productive way as you mention.

Thanks for your explanation and thoughts @luutzu! Really appreciate it.


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## luutzu (23 October 2018)

CBerg said:


> The sector I’ve been looking into is IT so some of the revenue is probably software licensing and some probably upfront payments for projects.
> 
> I guess the interesting thing to me is if there’s enough unearned revenue there’s the potential that they’re getting their/part of their working capital for free provided it’s being used in a productive way as you mention.
> 
> Thanks for your explanation and thoughts @luutzu! Really appreciate it.




Yea, money coming in early is always good. A bit like insurance floats; the reverse of businesses giving away inventory on IOUs, allowing them to report higher revenue but the cash might never comes back.

I guess that's why it's important to understand the underlying figures and not take them (all) at face value. Not all liabilities are debt and not all revenue are cash. 

I also found examining the cash flows paint a better picture of the business than its income statements alone. 

Cash is what's transacted and in or out of the pocket. Income and expenses are for the taxman and the investors to look at and be impressed (or not).

Becareful of businesses reporting higher net profit than their net operating cash flow.


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## Klogg (23 October 2018)

CBerg said:


> The sector I’ve been looking into is IT so some of the revenue is probably software licensing and some probably upfront payments for projects.
> 
> I guess the interesting thing to me is if there’s enough unearned revenue there’s the potential that they’re getting their/part of their working capital for free provided it’s being used in a productive way as you mention.
> 
> Thanks for your explanation and thoughts @luutzu! Really appreciate it.




Only one thing to add. If the revenue stream is consistent, then having deferred revenue can be seen as a free loan (that is, it's 'borrowing' from those who pay in advance, at an interest rate of 0%). Put another way, it allows for a company to run with negative working capital.

Basically, their current liabilities are greater than current assets, and the more the business grows, the bigger that gap becomes. Navitas runs this model, and has successfully done so for some time. Typically, education providers and SaaS offerings use this model. From memory I think some novated leasing companies do the same (SIQ, MMS, SGF), but I can't remember the specifics of their respective balance sheets.

It does introduce risk, so be careful.


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## CBerg (23 October 2018)

luutzu said:


> Yea, money coming in early is always good. A bit like insurance floats; the reverse of businesses giving away inventory on IOUs, allowing them to report higher revenue but the cash might never comes back.
> 
> ...
> 
> Becareful of businesses reporting higher net profit than their net operating cash flow.



You drop some great nuggets of wisdom sometime and it just makes thing click for me. The point about NP higher than OCF is a good one! I remember not long ago you were talking about equity and you want the capital contributed to stay the same/not grow outrageously and have the retained earnings on the up and up. I never paid too much attention to the equity section of the balance sheet but I am watching and learning as I continue to study the reports


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## CBerg (23 October 2018)

Klogg said:


> Only one thing to add. If the revenue stream is consistent, then having deferred revenue can be seen as a free loan (that is, it's 'borrowing' from those who pay in advance, at an interest rate of 0%). Put another way, it allows for a company to run with negative working capital.
> 
> Basically, their current liabilities are greater than current assets, and the more the business grows, the bigger that gap becomes. Navitas runs this model, and has successfully done so for some time. Typically, education providers and SaaS offerings use this model. From memory I think some novated leasing companies do the same (SIQ, MMS, SGF), but I can't remember the specifics of their respective balance sheets.
> 
> It does introduce risk, so be careful.



Hi Klogg thanks for the explanation. Could you elaborate on the risks of the strategy? Slower revenue meaning less capital to work with? Having to borrow when not planned for?

I’ll have a look at the companies mentioned but I have trouble understanding financial companies as it’s not always straight forward for a beginner


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## Klogg (23 October 2018)

CBerg said:


> Hi Klogg thanks for the explanation. Could you elaborate on the risks of the strategy? Slower revenue meaning less capital to work with? Having to borrow when not planned for?
> 
> I’ll have a look at the companies mentioned but I have trouble understanding financial companies as it’s not always straight forward for a beginner




Firstly, just to clarify, by 'Slowing Revenue', I mean the amount the company is paid is slowing down. (Revenue being the total amount paid to the company)

Put it this way. If I have pre-orders and you've accepted cash for them (that is, deferred revenue) of $5mil and I've already used $4mil before delivering those orders, I only have $1m cash left.

If my orders dry up, but I haven't adjusted my cost base (staff levels, inventory management, whatever else is involved), then I have a cash crunch. I either borrow from a bank (if they'll lend to me, given my drop in revenues) or I sell off other assets.

SaaS offerings generally have a somewhat predictable flow of cash, but if people are custom ordering a product and paying up front (for example), it's an entirely different ballgame. So while the balance sheet shows no bank loans, there are still liabilities.

NVT is a good example, and while they're straightforward, the size of the company does make it a little difficult for a beginner. 
LYL is another with deferred revenue, but they also sit on a LOT of cash, so it's not quite the same model.


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## CBerg (24 October 2018)

Klogg said:


> Firstly, just to clarify, by 'Slowing Revenue', I mean the amount the company is paid is slowing down. (Revenue being the total amount paid to the company)
> 
> Put it this way. If I have pre-orders and you've accepted cash for them (that is, deferred revenue) of $5mil and I've already used $4mil before delivering those orders, I only have $1m cash left.
> 
> ...



Sorry Klogg I missed your reply yesterday. Yep makes a lot of sense and is definitely risky as you say if the revenue is not of an ongoing basis.

I had a quick look at NVT, it’s a cash machine.


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