Cash in the bank is an actual figure.
But revenue is a number that has to be accepted by accounting.
For early-stage businesses using a subscription model or a Software-as-a-Service (SaaS) model, confusing cash in the bank and revenue could put that startup at risk.
Collecting €120,000 from a contract, for example, would cause the cash balance to skyrocket immediately.
However, according to new accounting standards, the company cannot record that as income on its balance sheet immediately.
Instead, it must recognize the income earned as the service is provided over time.
When a company's financial model takes into account immediate revenue from collected contracts, the company's revenue growth rate is distorted.
Conversely, when a company's financial model only takes into account recognized revenue, the actual timing of cash inflow is lost in the model.
This makes runway calculations inaccurate.
The challenge of forecasting accurately is to create a structural framework that can capture both cash collections and revenue recognitions in an organized manner.
To do that, creating a systematic way to separate the collection of cash from the recognition of revenue is necessary.
Executive summary - Capital is not revenue
It is possible for a company to look extremely healthy in terms of growth metrics while at the same time, running out of cash.
On the flip side, a new company may seem unprofitable on paper while possessing millions of dollars in collected cash.
These discrepancies are called deferred revenue. Deferred revenue is a liability on the balance sheet of a business.
It represents the cash that has already been collected by the business from customers but not yet been provided in services or products.
To accurately forecast a new company's cash flow, finance teams must be able to separate these timing differences across the three major financial statements.
The income statement
The income statement recognizes revenue when a company meets its performance obligation. This happens regardless of when it bills for that revenue.
The balance sheet
The balance sheet classifies deferred revenue as a current liability. This liability decreases as the company delivers its service.
The cash flow statement
The cash flow statement shows the change in accrued revenue as the actual cash revenue earned from operating activities.
If the three statements are not kept separate, hiring plans, marketing costs, and engineering road maps will be based on accounting figures that do not represent reality.
This oversight can leave a company at risk for unexpected cash flow difficulties.
The difference between GAAP revenue and cash revenue
In order to understand how to structure the model, the different accounting standards of revenue recognition must be examined.
The fundamental difference between GAAP and IFRS
Under both US GAAP (ASC 606) and IFRS (IFRS 15), the recognition of revenue is totally independent of billing.
Under ASC 606 and IFRS 15, revenue recognition is based on a five-step process that is driven by the transfer of control to the customer.
For example, when a startup sells a €120,000 software subscription for a 12-month period and receives payment on the first day of service, the balance of the cash account increases by €120,000.
However, the startup has not yet satisfied the performance obligation. No revenue is recorded on the first day of service.
The full €120,000 appears on the balance sheet as deferred revenue.
As the startup continues to provide the software service over the next 12 months, €10,000 will gradually transfer from deferred revenue to recognized revenue for each month of service delivery.
The trap of the illusionary runway
Companies that rely on the income statement to analyze the runway of their operations will make serious errors.
For example, consider a startup with €150,000 of monthly operational costs.
If the company closes three large annual contracts at the same time for €180,000 each in January, they bring in €540,000 cash.
On an accrual basis, revenue reported for January will be €45,000 (€150,000 per year divided by 12 months multiplied by 3 contracts).
If all the management team looks at is the €45k recognised revenue, they may panic when they see they have a huge gap for the month.
Conversely, if all they see is the bank balance of €540,000 and think they now have that much additional money for the month, they may be forced to hire people immediately.
However, that cash has to remain in the company and will enable service delivery over the next 11 months. It cannot be used in full in the first month.
Separating deferred revenue from cash flow in start-up forecasts
A functional forecast needs to be built using a specific scheduling tool. Simply using a flat percentage assumption will not work.
Step 1: Determine how you will bill your customers
The forecast needs to be reported in a contract ledger or billing schedule.
This is different than the revenue line, as billings indicate what has been invoiced to customers for the time period specified.
Bookings in your model will need to be segregated by contract type. These include monthly contracts, annual pre-paying contracts, or multi-year contract terms.
For example, if your model calls for new bookings totalling €200,000 for Q1, you will also need to know how these new bookings will be billed.
If 70% of these bookings are annual pre-pay contracts, the Q1 billings line will reflect the level of concentration.
It will pull cash into the model far in advance of when it appears as revenue.
Step 2: Create a waterfall schedule to trace deferred revenue
The waterfall schedule allows you to easily trace how much deferred revenue has been billed but not yet recognised for each period for each billing cohort.
To create a waterfall schedule in a spreadsheet, establish a table containing columns for each calendar month and rows for the historical billing cohorts.
To compute the totals for a given month, use a generic roll-forward calculation.
Add the beginning balance of deferred revenue and the current month's billings, then subtract the current month's revenue recognition to find the ending balance of deferred revenue.
As an example, in the case of an annual contract being billed in month one of the forecast period, you would divide the total invoice amount by 12.
This determines the monthly revenue recognition across the next twelve months and is used when creating your spreadsheet model.
This allows you to easily track the monthly recognition of all billed revenue based on its original performance lifecycle.
Step 3: Incorporate waterfall recognised revenues into the financial model
All of the recognised revenues and deferred revenue balances from the waterfall schedule will become part of the overall financial model.
Therefore, they dynamically link back to the financial statements.
The recognised revenues from the waterfall schedule become the top line of the income statement.
This is ultimately used to calculate gross margin, operating income, and net income.
The deferred revenue balance from the waterfall schedule is also recorded in the liabilities section of the balance sheet.
Lastly, under the indirect method, the total net income amount will be taken directly from the income statement and adjusted for changes in working capital in the cash flow statement.
Calculation of the change in deferred income or revenue from the previous month is a key component of determining net income for the month.
Deferred income is considered cash received but not yet recognized.
The amount of deferred income will always be added back to net income on the operating cash flow statement.
This is due to the fact that it represents an increase in cash inflow.
Whereas a decrease in deferred income means that a company recognized some of its revenue in the past without receiving any new cash during this time and must therefore deduct this decrease from net income.
Modeling the real-world volatility of churning customers, upgrades & contract variations
Startups experience an ongoing flux of contracts. Because of cancellations, downgrades, and modifications, using a static model with a perfect 12-month revenue delivery cycle will likely prove ineffective within the real world.
The negative impact of churn on deferred revenue recognition
When a customer cancels an annual contract in the middle of that year, the accounting treatment of that cancellation is dependent on the terms of the customer's contract.
If the contract states that the revenue is non-refundable, the deferred balance will be accelerated and recognized as revenue, since the performance obligation has been terminated by law.
However, from a cash flow viewpoint, there is no new inflow of cash into the business.
The financial model must show this revenue acceleration on the income statement, while showing zero recognition of cash inflow from this event on the cash flow statement.
If a partial refund of the contract is permitted, then cash will flow out of the business.
Any remaining balance of deferred income liability will be eliminated without impacting revenue.
Contractual accrual accounting treatment in multi-year agreements
As startups continue to grow and mature and take on larger deals, the signing of multi-year contracts will become more commonplace.
A large payment created through an annual upfront contract of €300,000 for a contract with a 3-year length creates an immediate cash injection into the business.
Deferred revenue represents amounts received before the performance of goods and/or services.
Therefore, it would need to be split out on the balance sheet.
Current deferred revenue
This portion will be recognized in the next 12 months, equating to €100,000.
Non-current deferred revenue
This portion will be recognized in Year 2 and Year 3, equating to €200,000.
In order for a business to accurately display a clear picture of its working capital health, long-term liabilities should be tracked separately.
This ensures they do not distort operational metrics.
Long-term deferred revenue misclassified as a short-term source of liquidity creates an inaccurate operational metric.
Integrating short and long-term operational models
Though standard Financial Planning and Analysis (FP&A) have traditionally worked on a monthly time frame, managing short-term liquidity requires a tighter approach.
Start-ups that are on the verge of exceeding their current capital reserves will benefit from utilizing the 13-week cash forecast approach.
Comparing weekly vs. monthly FP&A models
Monthly models aggregate the varied data points into one cohesive number so that the fluctuations in the cash flow cycles are not easily seen.
For example, consider a business that receives a €300,000 annual contract payment on the 30th of every month.
If they complete their monthly FP&A report, it displays a healthy cash position during that period.
However, their bank account will not reflect the actual cash flow mid-month.
They will be in a period of technical insolvency even with positive cash flow during that month.
The 13-week cash forecast model does not utilize gap accounting conventions.
As a result, the timing of invoices generated through billing systems will be used as a direct comparison to any outgoing vendor payments or payrolls.
The FP&A model forecast provides the strategic goal a year out. The 13-week operating forecast supports the business to get to the goal a week at a time.
Reality check: Knowing how to present to investors
Smart investors look beyond the top line metric.
Investors know aggressive billing terms can inflate a cash position while masking core business flaws.
Constructing a one-page cash to recognized revenue bridge
When you are presenting a forecast to the board of directors or at the time you are raising capital, having a clear reconciliation bridge is critical.
You should provide a chart comparing Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR) to cash collections.
The following table lays out the data:
| Metric | January | February | March | Total Q1 |
| New Billings Invoiced | €300,000 | €50,000 | €75,000 | €425,000 |
| GAAP Recognized Revenue | €25,000 | €29,167 | €35,417 | €89,584 |
| Ending Deferred Revenue Liability | €275,000 | €295,833 | €335,416 | €335,416 |
| Net Operating Cash Flow Impact | €275,000 | €20,833 | €39,583 | €335,416 |
This format communicates management's insight into the business's unit economics.
It shows that the cash from customers is received in advance because of annual billing. It also demonstrates that the revenue run-rate aligns with customer delivery.
This breakdown of cash flow allows investors to assess the company's real underlying growth.
It ensures that runway calculations are based on actual capital and not on accounting-based adjustments.
Connecting operational systems and a financial forecasting model
Forecasting revenue using a model is only as good as the inputs into the model.
The number of transactions that an early-stage startup has will make keeping up with manually updating a complicated waterfall in a spreadsheet untenable.
Connecting the accounting and customer billing engines
Operational data is typically collected by a Customer Relationship Management (CRM) platform.
That platform will then interface with a billing engine such as Chargebee, Stripe Billing, or Zuora.
The billing engine will send transaction data to the General Ledger (GL) software once the transactions have been processed by the billing engine.
During the process of sending transaction data between the different platforms, errors are common.
For example, if Stripe processes an annual payment, it may not send the details pertaining to the term of the agreement.
This causes a deferral account to either incorrectly recognize the entire payment upfront or incorrectly flag the payment.
To ensure that the forecasting model used by the finance team is accurate, the finance team will need to create automated revenue recognition sub-ledgers in their GL software.
The sub-ledgers will have modules that will link transactions back to their deferred revenue accounts by way of their product code.
Subsequently, the finance team should reconcile periodically to ensure that the deferred revenue account on the balance sheet matches the remaining open value of the active customer contracts.
Conclusion: Liquidity does not equal performance
Separating cash flow from deferred revenue should not be considered a theoretical exercise in compliance with GAAP.
It is an important element of financial strategic planning.
Numerous operational mistakes are created when cash collections and recognized income are mixed together.
When this happens, it creates an inaccurate picture of the company's financial health during peak times of cash collection.
It also hides any underlying performance issues if the billing volume declines.
By creating an integrated forecast based on a structured waterfall timetable, the leadership team of a start-up can have an accurate, dual lens view of their financials.
They can see what cash they will need to pay payroll in the upcoming week.
They will also see exactly what recognized revenue will establish the company's valuation for the next round of funding.
Frequently Asked Questions (FAQs)
What effect do increases in deferred revenue have on cash flow statements?
Whenever there are increases in the deferred revenue account, this means the company has received cash from customers prior to providing their product or service.
The increase in this account on the Cash Flow Statement created using the indirect method is added back to the operating income section.
This equates to net income plus increases and minus any decreases in deferred revenue.
The increase in deferred revenue indicates a positive cash flow that is not yet recognized as income on the Income Statement.
Why do investors pay so much attention to deferred revenue even though it is already in your bank account?
Investors pay so much attention to deferred revenue because it is a proxy for future revenue that will be recognized when the company delivers the products and services to the customer.
It is also an indicator of the long-term health of the company.
A company that is experiencing continued growth in deferred revenue has a large volume of forward bookings and has been effective at collecting cash.
However, if deferred revenue is decreasing even though the company has a large cash balance, this means the company has experienced a decline in bookings.
They are recognizing current revenue from prior sales as opposed to acquiring any new customers.
How should you visually represent multi-year contracts in your start-up forecast?
Multi-year contracts that are billed upfront must be separated based on the timing of the performance obligations.
The portion of the contract value that will be recognized in the next year should be classified as a current liability in deferred revenue.
The remaining balance that will be recognized in year 2 and beyond would be classified as a non-current liability in long-term deferred revenue.
When the cash is collected it is recorded immediately on the cash flow statement. Revenue will be recognized over the multi-year contract period methodically.
What is one of the most common errors that occur when building a deferred revenue waterfall?
One of the more common formula errors that occur when building a deferred revenue waterfall is that the recognition logic is not dynamically linked to changes in contract terms or cancellation dates.
Many formulas assume that there will be a straight line, uninterrupted distribution of the contract over 12 months.
They do not allow for mid-term cancellations, upgrades or temporary contract freezes.
If a contract is terminated before the end of the 12 months, the remaining balance of deferred revenue must either be pushed ahead or reversed.
Any assumptions in the waterfall columns must be hard coded into them.
