Note: this was originally published at https://alexoppenheimer.substack.com/
Happy Accounting Monday!
This post is pretty accounting-ish, but hopefully helpful and not eye-glaze-inducing. I have found that it's not clear what revenue actually is and how all the other affiliated terms fit into a specific business and its operations and accounting. As many of you know, I often work with companies selling digital subscriptions, so while there might be other sector-specific definitions, I am generally writing in the context of SaaS.
- Revenue: According to ASC606, "revenue is recognized when the performing party satisfies the performance obligation," or more simply the goods/services are delivered to the customer. The amount of revenue that is recognized depends on the contract, pricing and timing of the delivered good/service. So what is the takeaway from all this jargon? Revenue is recognized (that is its verb), and has almost nothing to do with cash collected, only with goods/services delivered as per an associated contract, and over a certain period of time.
- Bookings: The total (TCV) or annual (ACV) value of the contracts signed during a certain period of time.
- Backlog: The undelivered goods/services associated with an signed contract. This is a good example of backlog, which often involves time-intensive manufacturing and represents an order book that will yield both revenue and payment in the future once the goods are built and delivered.
- MRR: Monthly recognized revenue from recurring contracts. This is my definition. I like it because it allows you to move between the accounting world and the operational SaaS world with a single metric. It's worth noting that this number is likely going to be very slightly lower than the total value of monthly contracts at the end of any given month (another definition of MRR) due to how revenue gets recognized and deferred in SaaS contracts on a monthly basis. The numbers you pull from Salesforce vs. Quickbooks might actually differ - this is why.
- ARR: Annualized Recurring Revenue. MRR x 12. He we are simply annualizing the monthly run rate. ARR represents the amount of revenue you will recognize from your current recurring contracts (if nothing changes in those contracts) over the next year. You can annualized from any other period of time... weekly, daily, hourly, but for most companies the month → year seems to align the best for budgeting, contracts and operations.
- Billings: The dollar value of the invoices that you sent out to your customers in any given period. This includes the annual contracts that are billed upfront in addition to any monthly contracts.
- Collections: How much cash came into your bank account over a given period. This is undoubtedly a good thing, but it is not representative of the operations of a business, rather the cash cycle dynamic of that business. Cash is still king, but tread lightly with this metric, if used incorrectly it can lead you down a road of long term unprofitability.
- Accounts Receivable: When the goods/services associated with a customer contract are delivered, but not yet paid for by the customer. The seller is effectively giving the customer a free loan in the form of delayed payment for the good/service. This goes on the balance sheet as an asset. From a modeling perspective, we look at "days sales outstanding" which is an important timing element in the net working capital dynamics of a business and overall cash cycle.
- Deferred / Unearned Revenue: When customers pre-pay for a good/service, you create a liability (which lives on the balance sheet) due to the obligation the company now has to deliver the good/service to the customer. Pre-payment = operating loan = negative net working capital = source of cash = 👍. This is one of the powerful things about the SaaS business model - annual upfront pre-payments for a service that has low variable cost and zero manufacturing / shipping time and expense. If you see a big jump in deferred revenue period to period, it means that the company is going to be recognizing a lot of revenue in the future.
- Revenue Recognition: Going to lift this one straight from Investopedia because it's well-written.
The revenue recognition principle, a feature of accrual accounting, requires that revenues are recognized on the income statement in the period when realized and earned—not necessarily when cash is received. Realizable means that goods or services have been received by the customer, but payment for the good or service is expected later. Earned revenue accounts for goods or services that have been provided or performed, respectively. The revenue-generating activity must be fully or essentially complete for it to be included in revenue during the respective accounting period. Also, there must be a reasonable level of certainty that earned revenue payment will be received. Lastly, according to the matching principle, the revenue and its associated costs must be reported in the same accounting period.
Thank you to investopedia for some of the detailed lingo.
These revenue-related metrics all have varying levels of importance for each type of business, and understanding what they represent will help any operator better report on and direct their business long term.
Feel free to reach out directly with questions about what they (and any others) mean in a specific business. Happy to try to help figure it out. The two images below represent how this stuff makes me feel.