If you are a SaaS business, you must read this article to know:
- What is a SaaS Financial Model?
- Components of a SaaS Financial Model
- How To Create a SaaS Financial Model for Forecasting Performance?
As a SaaS business owner, you understand how important it is to build or have in place an appropriate, rolling integrated 3-way financial model.
A 3-way generic financial model is the one that inter-links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model. Most industrial or other traditional software businesses use the 3-way generic financial model.
Likewise, subscription-based businesses like SaaS also use a 3-way financial model that includes SaaS P&L, SaaS Balance Sheet, and SaaS Cash Flow Statement. However, the SaaS financial model incorporates certain components and performance metrics that are separate from the ones showcased in the generic financial model.
For instance, the SaaS financial model incorporates SaaS Revenue forecasted based on various pricing models. These revenue pricing models range from basic users to contract-based subscriptions with prepaid revenue. In addition to this, a SaaS financial model reports the complexities of the different revenue pricing models. The complexities may include deferred revenue and revenue recognition from prepaid subscription models.
Besides this, the financial model showcases COGS projections based on SaaS-based drivers such as leads, users, or new users. Also, it displays the Customer Acquisition Costs showcasing the amount of investment required to get new customers on board.
Apart from the above-mentioned components, the SaaS chart of accounts showcases performance metrics calculated using growth drivers, profitability drivers, and sustainability drivers.
So, to help you build an appropriate financial model for your SaaS business, in this article we will look at the various SaaS revenue models. Apart from this, we will also discuss the key SaaS metrics and the chart of accounts that are the foundation of building a SaaS financial model for forecasting performance.
What is a SaaS Financial Model?
SaaS Financial Model is a procedure of modeling the financial data of a subscription-based business like SaaS and integrating it with the customer analysis of such a business. The model is scalable and showcases historical, current, and forecasted financial data of a SaaS business. In addition to representing the financial data, a SaaS Financial Model also presents key SaaS metrics that business owners and CFOs must track for accurate reporting of business performance.
Note that a SaaS financial model is different from the traditional financial models. It takes into account the complexities of recurring subscription revenues, churn, and the impact it has on the forecasted revenue.
Also, the SaaS financial model accounts for the complexities that arise due to the subscription-based model of a business. Note that a SaaS business typically incurs huge costs in its early stage. This is because the entire focus of such a business is on acquiring new customers.
However, the customer acquisition efforts undertaken now generate revenue over a period of time as and when the product or the service is delivered to the customers. Thus, it is important for a SaaS business to track customer retention and reduce its customer churn.
Also, each SaaS business must use financial models that are customized as per its requirements.
Importance of a SaaS Financial Model
Using the generic financial model based on GAAP principles for a SaaS business may fail to capture a true and fair view of its operating performance. This is because the manner in which incomes and expenses are recognized for a SaaS business vary significantly as compared to an industrial or a traditional business using a generic financial model.
For instance, a SaaS-based firm invests significantly in intangible capital like innovation, advertising, information technology, human capital, and customer relations. It showcases such intangible capital investment as an expense in its income statement.
This is unlike an industrial, material-intensive firm that invests a significant amount of capital on tangible assets like plant and equipment, land and building, and machinery. Further, it showcases tangible capital investment as assets in its balance sheet and capitalizes such investments over their lifetime in the income statement.
Thus, SaaS firms are likely to showcase high volatility in their revenues and cash flows, specifically in their early stage, if they use a generic financial model for forecasting.
On the other hand, a SaaS financial model represents a strategic framework for increasing the growth, profitability, and sustainability of a SaaS business. It considers key strategic drivers and presents metrics that help various stakeholders have an understanding of the operating performance of a SaaS business.
Thus, a SaaS financial model is important as it helps CEOs and CFOs of a SaaS business to:
- Identify, track, and communicate the most relevant performance metrics
- Undertake and execute key strategic decisions
- Recognize revenues effectively
- Analyse pricing and profitability
- Drive changes in business model
- Forecast financial data accurately
- Accrate assessment of financial and operational health of the business
- Avoid surpassing the benchmark burn rates
Components of SaaS P&L Statement
SaaS P&L refers to the income statement of a subscription-based business like SaaS that demonstrates its profitability and performance over a given period of time. The metrics used to assess the performance and profitability of a SaaS business are separate from those of a traditional software business. This is because a SaaS-based business has a unique business model.
Thus, SaaS P&L is a financial tool that helps in evaluating the accurate financial and operational health of a SaaS business. It is important for SaaS business owners to understand the growth drivers and the underlying components relevant to their business.
Note that SaaS businesses are based on recurring revenue models. Hence, it takes a long period of time for them to derive returns on their investment as compared to traditional software companies.
The following section charts out the components of a SaaS P&L and the underlying drivers to evaluate the growth and profitability of a SaaS business.
I. Subscription Revenue
Typically, a SaaS business derives its revenues primarily from two sources: subscription and support revenues and related professional services. Subscription and support revenues refer to the subscription fee received from customers in return for accessing a SaaS business’s cloud-based services. Such revenue accrues and is recognized over time in the books of a SaaS business.
Subscription revenue also includes professional services contracts. Such contracts can either be on a time and materials, fixed fee, or subscription basis. These revenues are recognized as the services are rendered for time and materials contracts, on a proportional performance basis for fixed-price contracts, or ratably over the contract term for subscription professional services contracts.
A SaaS business must evaluate its revenue by tracking revenue drivers like bookings, calculated billings, recurring revenue, deferred revenue, and backlog.
Key Revenue Metrics For SaaS
These refer to the sum of all the closed deals in a particular year.
b. Calculated Billings
It refers to the sum of revenue generated during a period (i.e. a quarter) and the change in the deferred revenue from the prior quarter to the current quarter.
c. Recurring Revenue
Recurring Revenue refers to the amount of revenue that a SaaS business collects over a stated period of time. In SaaS businesses, recurring revenue refers to the revenue generated in the form of the subscription fee for accessing the software as well as cloud-based services.
d. Average Revenue Per User (ARPU)
Average Revenue Per User (ARPU) is another key SaaS metric that measures the average amount of revenue that each user generates over a given period of time.
Backlog refers to the deferred revenue from Bookings that a SaaS business has not yet recognized in its books of accounts.
f. Annual Contract Value
Annual Contract Value (ACV) refers to the average of the Annual Contract Value of all the subscription agreements that a SaaS business has entered into.
Also, a SaaS business may look into the following components when analyzing its ACV.
- New ACV: ACV from new customer contracts
- Upsell ACV: These include additional sales made to the existing customers.
- Recurring ACV: ACV from existing subscription contracts
- Churn: Loss of customers or revenue during a period of time
- Downsell: Portion of bookings that downgrade or reduce the scope of their current subscription
- Net ACV: ACV from new and existing customer contracts for a particular year adjusted for the lost ACV due to customer churn.
- Number of New Customers: Number of new customers acquired over a given month.
- Number of Lost Customers: Number of customers lost over a given month.
II. Cost of Revenue
The cost of revenue of a SaaS business represents the cost of subscription and support revenues. These are the expenses that relate to delivering SaaS service and providing support to the subscribers. Such costs may include costs of data center capacity, fees paid to third parties for the use of their technology, services, and data, and employee-related costs such as salaries and benefits.
Likewise, the cost of revenue also includes the cost of professional services. Such costs primarily consist of employee-related costs associated with these services, including stock-based expenses, the cost of subcontractors, and certain third-party fees.
A SaaS business may have to track key cost of revenue metrics to analyze its profitability.
Key Cost of Revenue Metrics For SaaS
a. Customer Acquisition Costs (CAC)
CAC refers to money that a business spends to acquire a new customer. This includes costs associated with marketing and sales that e-commerce businesses incur in order to attract potential customers to purchase their products.
b. Cost To Serve (CTS)
Another important cost component that impacts the profitability of a SaaS business is Cost To Serve (CTS). If a SaaS business wants to effectively manage this metric, then it needs to have in place proper product and database server architecture.
III. Operating Expenses
The operating expenses of a SaaS business refer to the expenses that help the business to run its normal day-to-day operations. Such expenses may include selling and marketing expenses, research and development costs, General and Administrative Expenses.
a. Research and Development Cost
Research and development expenses consist primarily of salaries and related expenses, including stock-based expenses and allocated overhead.
b. Sales and Marketing Cost
Marketing and sales expenses primarily consist of salaries and related expenses, including stock-based expenses and commissions, for the sales and marketing staff of a SaaS business.
It also includes payments made to partners, costs spent on marketing programs and allocated overheads.
c. General and Administrative Expenses
General and administrative expenses consist primarily of salaries and related expenses, including stock-based expenses, for finance and accounting, legal, internal audit, human resources, and management information systems personnel, and professional services fees.
Key Expesne Metrics For SaaS
a. R&D as a % of Sales
This metric helps a SaaS business in comparing its strength. This is because such a metric reveals the effectiveness of research expenditure as compared to the overall sales of the SaaS business.
b. Sales Cost and Marketing Cost as a % of ARR
Sales Cost and Marketing Cost as a percentage of Annual Recurring Revenue (ARR) of a SaaS business showcases the relative amount of its sales and marketing expenditure to its ARR.
IV. Income Tax
This section represents the current and deferred tax amounts of a SaaS business. Assets or Liabilities arising under tax are recognized as amounts payable or receivable from or payable to the tax authorities.
Deferred tax assets and liabilities are determined based on temporary differences between the financial statement and the tax basis of assets and liabilities.
Accordingly, deferred income tax of a SaaS business represents the temporary differences at the balance date between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes.
V. Other Income and Expenses
Other expenses primarily consist of interest expense on debt that a SaaS business may have undertaken. It also includes operating and finance leases that are offset by investment income. The investment income may include interest received on marketable securities.
Likewise, the Other Income of a SaaS business may include gains on strategic investments that the business may have made. The strategic investments may include acquisitions or investments made in complementary businesses services, technologies, and intellectual property rights to complement the core development of the SaaS product.
Components of SaaS Balance Sheet
SaaS P&L refers to the income s
How To Create SaaS Financial Model?
The SaaS financial model is the foundation for building an integrated 3-way financial model of a subscription-based business like SaaS. Such a financial model can be built as a basic 3-way SaaS financial model and as a SaaS Scenario Analysis Model.
A forecast 3-way financial model consists of a host of interrelated parts. Such a model begins with the opening balance sheet, then it forecasts each item within the financial statements and finally ends with the linked financial statements. That is income statement, balance sheet, and cash flow statement.
This type of financial model is called an integrated 3-way model because it includes all three financial statements linked together using formulas. Thus, a firm can build a financial model in the following order:
- Financial statements
- Revenue & expenses
- Working capital
- Fixed assets
- Debt & equity
- Corporate taxation
- Other financial statement items
This is the modular financial modeling approach that simplifies and enhances the process of building the model.
The following workbook will help a SaaS business to start with the financial model building process. Note that it includes a hyperlinked table of contents within the overview sheet. Such a table provides an overview of the model structure and single-click access to the content within it.
This hyperlink-based navigation is used to move between the excel sheets. Further, it allows the user to refer to the sheets using sheet titles displayed in the table of contents instead of sheet tab names.
I. Begin With Opening Balance Sheet
The first step to build a financial model is to create financial statements and inter-link them. To build the remaining financial model, ensure that the balance sheet remains balanced always.
Note that a forecast-only financial model begins with an opening balance sheet. Then, a firm must populate the financial data within the financial statements. When doing so, the firm must ensure that it links the data from each of the areas within the financial model systematically. It can begin with revenue and then work through expenses, debtors, inventory, creditors, fixed assets, etc.
The firm needs to end the financial model with an integrated forecasted income statement, balance sheet, and cash flow statement.
It is important to note that there are two primary links between the three financial statements:
- Net profit after tax (NPAT) from the income statement links to the equity section of the balance sheet, adding to retained profits; and
- The net change in cash held from the cash flow statement links to the current assets section of the balance sheet, adding to cash at bank.
Once a firm builds these primary links between the financial statements, the other links to and between the statements must have a net balancing impact on the balance sheet. The image below showcases such an impact:
A firm can use this to understand any financial statement impacts and verify that their net impact will always have a balancing impact on the balance sheet.
In our example which is picked up from Modano, we will build a monthly rolling historical and forecast financial model of a fictitious SaaS business named Alsatian Software Ltd.
Note that Altasian is experimenting with different revenue models to determine its optimum pricing strategy and product/market fit. Before July 2020, Alsatian’s only source of revenue was uncommitted monthly subscribers. However, from July 2020 the business started offering discounted subscriptions to users agreeing to 12-month rolling contracts.
After both these revenue models turned successful, Alsatian started offering 6-month rolling prepaid subscriptions in October 2020. At present, the firm plans to start signing customized large contract-based subscriptions by April 2021.
The following is a summary of the historical and forecast revenue of the business based on these four revenue models. This summary also showcases the cost of goods sold and operating expenditure data for the business.
Altasian needs to incorporate the above data into a rolling driver-based financial model. Such a model will guide the firm with regards to its ongoing business growth. Further, this financial model will reflect the different revenue models that Alsatian implements. That is, it will showcase the modeling of deferred revenue for prepaid subscriptions, and incorporate all the common SaaS modeling metrics.
Thus, to start with the building the SaaS financial model, Altasian needs to zero down on appropriate chart of accounts, time-series, and a variant.
The SaaS chart of accounts includes SaaS P&L, SaaS Balance Sheet, and SaaS Cash Flow Statement.
Likewise, Altasian can choose different time series constructs to prepare its financial model.
Say, for instance, Altasian requires monthly analysis with annual financial statements. Thus, it must build monthly time series constructs and then create annual financial statements modules.
The following are the various time series constructs that Altasian can use to prepare financial models as per their need:
- Historical and forecast data
- Monthly, Historical & Forecast time series
- Monthly, Quarterly, Semi-Annual and Annual time series
- Weekly, Historical & Forecast time series
Finally, a variant refers to the structure of a modular driver-based financial modeling with assumptions and outputs. Note that from the point of view of the financial statements, the primary difference between a SaaS financial model and a generic financial model is the reporting of deferred revenue.
The other ways in which a SaaS financial model differs from a generic financial model are as follows:
- SaaS Revenue: Forecated SaaS revenue is based on drivers that are determined depending upon different pricing models. These pricing models consider elements ranging from basic users to contract-based subscriptions with prepaid revenue.
- SaaS Deferred Revenue: SaaS financial statements report complexities of different SaaS revenue pricing models. These include deferred revenue and revenue recognition from prepaid subscription models.
- SaaS Cost of Goods Sold: Forecasts of SaaS COGS are driven by SaaS-based drivers such as leads, users or new users.
- Customer Acquisition Costs: Such costs demonstrate the amount of investment required to get new SaaS customers onboard.
- SaaS Metrics: The SaaS financial model reports in detail key SaaS metrics such as leads, conversions, users, churn, MRR, ARPU, LTV, CAC, etc
To build the forecast financial model, Altasian begins with the opening balance sheet. The balance sheet reflects assets, liabilities, and equity balances at the start date. Altasian makes use of these balances to forecast data. Then, it inter-links the forecasted balance sheet, income statements, and the cash flow statement as shown below:
In the above image, the opening cash and retained profits balance from the opening balance sheet are linked into the forecast balance sheet directly. Whereas, the other assets, liabilities, and equity accounts get reflected in the forecasted financial statements via relevant forecast areas within the financial model.
Note that in the financial model that we are considering as an example, Altasian builds the forecasts directly into the financial statements. In addition to the connection showcased in the above image, the financial statements will comprise direct references to the opening balance sheet as well as each other.
This approach has been taken to keep the exercise duration reasonable but is not recommended when building real-life financial models as it makes the resulting financial model much messier and risker.
However, while building a financial model in real life, a SaaS firm must build the forecasts for each part of the model (e.g. revenue, expenses, debtors, etc.) outside of the financial statements. Once this is done, then it must link each financial statement line item into the financial statements using simple formulas.
Altasian enters the total assets and total liabilities, and total equity into its opening balance sheet within the financial model. Note that when the model is complete, the data within each part of the financial model reconciles with the data in the annual report.
The Altasian financial model initially contains a total of 24 months starting on 1st January 2020, with 12 historical months ending in December 2020, as shown below:
Note that the opening balance sheet comprises of assets, liabilities, and equity. Also note that the net assets are equal to assets minus liabilities. This means that to balance the balance sheet to balance, a SaaS firm must ensure that its total equity is always equal to the net assets.
Then, a SaaS firm must enter closing cash balance into the cash assumption cell J6. This will result in total assets being equal to cash as shown below:
As showcased in the image above, a SaaS firm will have to use a formula to calculate retained profits as the balancing item in cell J34. The firm needs to ensure that the opening balance sheet remains balanced always as it is populated with assumptions.
In addition to this, a SaaS firm needs to ensure that the forecast balance sheet remains balances while building the financial model. To achieve this, the firm should not enter any other opening balances into the opening balance sheet while building the financial model. This is because in our financial model, the opening balances for each forecasted area are entered automatically as these are included within the model itself.
II. Prepare Forecasted Income Statement
The SaaS P&L statement showcases the revenue and expenses of a SaaS business. It determines the net profit after tax (NPAT) and hence is also called profit and loss statement, a statement of financial performance, or a statement of operations.
The SaaS revenue modules facilitate the forecasting of revenue based on the following four pricing models:
- Uncommitted Users: These is the ongoing uncommitted user base of a SaaS firm, with general prevailing user price.
- Contracted Users: It refers to the user base that is committed to a SaaS firm contractually, with no prepayment.
- Prepaid Subscriptions: This pricing model involved contracts that are invoiced on the first day. However, the revenue recognition within the income statement and the recognition of deferred revenue in the balance is undertaken over contract life.
- Large Contracts: These are the rolling contracts based on a specified value, with or without prepayment.
Altasian uses a combination of the above-mentioned pricing models in its SaaS model.
Note that the SaaS revenue module components are located on the SaaS Revenue sheet. This sheet showcases all-time series periods to facilitate the analysis of SaaS metrics within both historical and forecast time frames as shown below:
The first part of this sheet is the Historical SaaS Deferred Revenue module component. Altasian uses this component to manage the roll-off of the SaaS deferred revenue reported in the historical income statement.
In the remaining sheet, Altasian undertakes SaaS revenue calculations by revenue stream. Each revenue stream is identified with the help of Heading 2 title rows. For instance, the UCAN heading row 32 above.
A SaaS business can insert new revenue streams. Further, such a firm can duplicate, mirror, delete, or customize the existing SaaS revenue streams as per its pricing strategies.
As mentioned earlier, Altasian makes use of different pricing models. We will showcase how each of these is incorporated in the financial model in the following section.
Scenario I: Contract Without Any Complexities (Uncommitted Monthly Users)
Uncommitted monthly users in the case of a SaaS business give an ongoing monthly charge to the business, unlike contracts in which users sign contracts for a fixed period at a contracted rate.
Thus, there are no contract commitments or prepayments in the case of the uncommitted monthly users.
In our example, a SaaS business prepares forecast estimates for the growth in new users. To do so, it takes the historical income statement into consideration.
Many SaaS businesses focus on acquiring users in addition to focusing on tracking users. To determine the number of acquired users, businesses prepare a schedule of forecast leads and conversion rates as shown below:
By considering the above assumptions, the balance for closing users at the end of December 2021 comes out to be 25,130.
Note that this scenario represents the calculation of revenue and growth in users considering the uncommitted monthly users. Thus, there are no specific contracts or commitments. Furthermore, there is no specific price linked with each user based on when each of them started using the SaaS product or service.
In addition to determining the number of customers acquired, a SaaS business also considers customers acquired organically via word of mouth or digital media. Thus, to track such growth in new users, the SaaS business determines forecasted estimates as shown below.
Thus, using the above assumption of 1% growth in new users, the closing users at the end of December 2021 increases to 27,053.
In addition to user acquisition and the inbound funnel, SaaS businesses also monitor the customers they lose. The rate at which SaaS businesses lose customers over a period of time is referred to as user churn.
Thus, a SaaS business will have a lower churn rate if the product or the service that it sells is of high quality. The better the product, the lower the churn rate. Then, the lower the churn rate, the higher the value of any user.
The following image showcases a 12-month profile of user churn rates for a SaaS business with regards to its uncommitted monthly users.
Note that the SaaS business expects to lose 2.5% of its opening users each month. For instance, the business expects that 49 customers will abandon its product or service in the month of March 2021.
After undertaking calculations using the above assumptions, the closing users at the end of December 2021 are forecasted to be 24,887.
Thus, the SaaS business adjusts the conversion of leads and user churn into the Opening Users balance to calculate its ongoing user base. The ongoing user base of the SaaS business is nothing but the closing user balance each month.
Once the SaaS business calculates the closing balance of users each month, it then calculates the revenue derived from these users. Such revenue is calculated through charging the closing balance of customers with the ongoing monthly subscription fee.
Suppose, the SaaS business sells its product or service at a monthly rate of $60 per user. This rate applies to both the opening/existing and new users.
Thus, the SaaS Deferred Revenue financial model as showcased above now has a forecast of users as well as a monthly charge. This results in creating forecasted revenue for the business.
Note that the formula for the Forecasted Revenue for the SaaS business is simply opening plus new users, multiplied by the monthly charge. Accordingly, the forecasted revenue for the December 2021 month is $1,518,400.
The above images showcase the forecasted figures for users and revenue for a SaaS business. A SaaS business must also consider historical data to determine the revenue growth and business valuation.
Thus, a SaaS business must incorporate its financial and operational data for FY20 within the historical income statement for SaaS revenue analysis.
Note that the historical data related to the user numbers are more important for a SaaS business to consider. This is because the users give recurring revenue to a SaaS business which is of utmost importance for it.
Note that row 62 represents the monthly charge of $50 per user for the FY20. Considering this rate as the best average rate at which the users are charged, the SaaS business forecasts the price of $60 per user per month for FY21 starting January 2021. Such a rate will apply to the ongoing users as well as the new users brought on board in FY21.
As we can observe, the historical data for the closing balance of a number of users helps a SaaS business to determine forecasted data of closing users and new users. Note that the last historical period’s (FY20) closing users data provides the base to forecast user numbers for the upcoming financial year (FY21).
Likewise, the historical data for new users helps a SaaS business to calculate historical lead conversion and user churn rates. Both these financial performance metrics are important for a SaaS business
According to the above assumptions, the SaaS business has 2,721 closing users in December 2020. This provides a base to the SaaS business to forecast a number of users and revenues for FY21.
A positive change in the number of closing users of a SaaS business represents the net new users. Whereas, a negative change in the number of closing users of a SaaS business represents the churn rate.
Note that a SaaS business calculates the historical conversion rates using the leads data. Such data is extremely important for a SaaS business as it helps the business in understanding the manner in which its inbound funnel performs.
As in the example above, the projected closing users at the end of December 2021 is now 27,372 users.
Another metric that a SaaS business must consider is the historical user churn. Historical user churn data represents the rate at which customers abandon the SaaS product or service. The historical user churn is calculated using the previous period’s closing users, leads, conversation rates, and new users assumptions.
As a result, a SaaS can showcase the relationship between opening users, new users, user churn and closing users in the following manner:
Closing Users = Opening Users + New Users – User Churn
User Churn = Opening Users + New Users – Closing Users
Thus, for July 2020:
- User churn was 16 users,
- Opening users were 732 users
- New users were 255, and
- Closing users were 971 users
Note that the SaaS business with 16 user churn and 732 opening users had a churn rate of 2.2% during July 2020. This is one of the key SaaS metrics that helps a business in understanding its growth potential.
Scenario II: Prepaid Subscriptions
Another pricing model that a SaaS business may consider to record deferred revenue is the Prepaid Subscriptions Model. In this model, users pay a lower contract price in case they prepay their entire contract on commencement itself.
Let’s consider the same example as above to understand this approach.
- Contract duration is 6 months
- Price of contract is $180
- Contract Price reduced to monthly cost of $30 per user
Note that in this scenario, the SaaS business is satisfied earning reduced revenues at
lower risk. The risk is lower because the users pay the entire contract amount upfront thus eliminating the user credit risk.
Though the SaaS business earns reduced revenues at lower risk, this pricing model is challenging to interpret. There is no connection between the cash inflows from subscriptions and the timing of when that revenue is earned.
For this model, the SaaS business considers ‘Upfront Payment Users’ in place of the ‘Uncommitted Monthly Users’ as showcased below.
Note that the upfront payment users component within the SaaS revenue sheet contains a detailed analysis of both contract prepayments and deferred revenue as shown below:
Thus, including the prepaid subscriptions analysis in a rolling SaaS financial model increases the complexity. This is because in this scenario the SaaS business owner must align the recognition of revenue from contracts with their lifespan. They have to align contract revenue with the contract life despite the upfront payments made by the users.
To align recognition of contract revenue with the contract lifespan, SaaS business owners create a deferred revenue balance on the liability side of the balance sheet. In addition to this, they report the revenue recognized each month until the contract life on the income statement.
Let’s consider the following example to understand this approach:
- Contract Duration (in Months) = 6
- March 2021 Leads = 25,000
- March 2021 Conversion Rate = 4%
- March 2021 Prepaid Contract Value = $180
- September 2021 Contract Renewal (%) = 0%
The last assumption regarding Contract Renewal is taken as 0%. This is done to present a single isolated contract cycle of users, prepaying a 6-month contract but not renewing for simplicity.
A SaaS business would undertake the accounting treatment of Prepaid Contract Value of $180 in the following manner:
- Based on the accrual-based accounting concept, the SaaS business would recognize a monthly revenue of $30 over a period of 6 months.
- Then, it would create a liability of $180 in its balance sheet as a deferred revenue balance.
Note that there is a timing difference between when the revenue is recognized and when the cash is received for the given contract. Such timing difference leads to the creation of deferred revenue balance on the liability side of the balance sheet.
How? Well, assume that the contract is prepaid on the first day of March 2021. This means the customer pays $180 advance cash even before the SaaS business provides the product or service. This means it is yet to earn revenue. Such prepayment impacts the financial statements of the SaaS business in two ways.
First, it increases cash by $180 and creates a deferred revenue liability on the balance sheet of the same amount as shown below:
The SaaS business then releases the deferred revenue liability to the income statement by recognizing revenue in each of the next six months, including March 2021 itself. This release of the Deferred Revenue Liability sends such revenue to the income statement and reduces the deferred revenue balance with each month presented as follows:
Note that the upfront payment of $180 is invoiced in March 2021. This amount is then added to the closing deferred revenue balance. Then, the revenue of $30 each is recognized as forecast income statement revenue in each of the six months from March 2021. Also, the SaaS business reduces the closing forecast deferred revenue balance is reduced by the same amount each month.
See the Deferred Revenue Waterfall Excel image below to understand the effect of the above transaction on the income statement and the balance sheet of the SaaS business.
Note that the recurring revenue of $30 is recognized each month in the income statement of the SaaS business.
Besides this, the deferred revenue balance is showcased under the current liabilities. This amount declines each month by $30 per month over 6 months. It keeps on declining till the deferred revenue balance reduces to zero from $180.
Let’s understand the impact of the above journal entry on the cash flow statement of the SaaS business. The cash receipts reveal the following impact on the cash flow statement:
- Cash receipts of $180 for March 2021 consist of $30 in revenue and a deferred revenue movement of $150.
- Cash receipts amounting to zero from April 2021 to July 2021 consist of $30 in revenue and a negative deferred revenue of $30.
This is how a SaaS business needs to show the impact of a deferred revenue transaction in its income statement, balance sheet, and cash flow statement. In this, revenue is showcased as a cash receipt along with a cash-to-balance-sheet differential.
Then, there can be a case of cumulative deferred revenue balance while preparing Deferred Revenue Waterfall Excel. The cumulative deferred revenue balance consists of an ongoing mix of contracts. This increases the complexity of the analysis as the closing deferred revenue balance becomes an ongoing mix of contracts at various points in the entire duration of a contract.
Let’s understand the impact of the cumulative deferred revenue in the financial statements above.
As you can see, the analysis becomes challenging to understand when the deferred revenue balance aggregates multiple rolling contracts.
For instance, the closing forecast deferred revenue balance in April 21 is $417,360. This balance is a combination of:
- (2 months/6 months) x January 2021 contract ($149,040) = $49,680
- (3 months/6 months) x February 2021 contract ($164,160) = $82,080
- (4 months/6 months) x March 2021 contract ($180,000) = $120,000
- (5 months/6 months) x April 2021 contract ($198,720) = $165,600
Thus, the Cumulative Deferred Revenue for the Month of April 2021 is: $49,680 + $82,080 + $120,000 + $165,600 = $417,36.
Also, the revenue of $115,320 for April 2021 is one month of each of the above four 6-month contracts: $24,840 + $27,360 + $30,000 + $33,120 = $115,320
The next scenario while preparing Deferred Revenue Waterfall Excel is the rolling deferred revenue scenario. It combines the revenue and operational data for historical and forecast periods. In fact, historical balance sheet and forecast activity drive the deferred revenue through the rolling functionality.
To understand this approach, let’s assume that the users started making an upfront payments for the SaaS product or service in October 2020. This means that the deferred revenue balance showcased in the historical balance sheet of the SaaS business was created during the last 3 months of activity from FY20.
Note that the SaaS Deferred Revenue figures as showcased in the above image represent the creation of deferred revenue balance. In addition to this, the image also showcases the partial reduction of the deferred revenue balance from the first three months of the SaaS business’ prepaid user group. Note that the prepaid balance is split out by month of contract commencement.
Further, the SaaS business also showcases the remaining term of prepaid subscriptions sold in October 2021 – December 2021. To calculate these amounts, it makes use of the historical deferred revenue recognition assumptions as shown below:
Note that the SaaS business created the Deferred Revenue balance in October 2020. Then, it reduced the Deferred Revenue balance amount in a linear fashion over a period of 6 months up to March 2021. This is done by recognizing revenue of $12,960 in each period.
The closing deferred revenue balance of $183,660 for FY20 is reduced over the subsequent 6 months as showcased below:
Note that it is important for SaaS businesses to understand the fundamentals of reducing the Deferred Revenue balance to understand modeling and interpretation of the analysis of prepaid contracts.
The reduction in the Deferred Revenue balance does not mean the release of revenue to the income statement from the balance sheet. In fact, it is just a cash shield of non-receipt that is calculated to ensure that forecasted revenue does not also render into cash inflow. This effect is shown in the image below.
Note that the data in the above image is the historical revenue from the first three months of prepaid subscriptions from October 2020 to December 2020. This data is used for prepaid users analysis.
The following revenue worksheet showcases the historical users, leads, and new users.
In the prepaid contract value cell, the SaaS business assumesthe prepaid contract value for October 2020 to be $180. Considering the previous image, the new contracts created in October 2020 had a total value of 432 users * $180 = $77,760.
As a result, each month the total for the deferred revenue balance to be reduced over a period of 6 months would be: $77,760/6 months = $12,960
Just like the revenue module, Altasian prepares separate modules for debtors and creditors; fixed assets; debt and equity; revenues and expenses; corporate taxation, and other financial statement items. Note that apart from revenues, the other items in the case of a SaaS financial model are determined in the same way as in the case of the generic financial model.
III. Prepare Cash Flow Statement
The last module that a SaaS business needs to work on is the Cash Flow Statement module. This module provides a cash flow analysis of a SaaS business over a number of accounting periods. It showcases how changes in the income statement and balance sheet accounts affect cash and cash equivalents.
Note that the cash flow statement module collects cash inflows and outflows from modules within the operational, working capital, assets, capital, and corporate taxation modules in the SaaS financial model.
Further, it links the changes in cash during each period with the SaaS balance sheet. The module also links out:
- Cash flow available for dividends to the ordinary equity module and
- The cash flow available to equity, cash flow available to capital providers and tax paid to the valuation modules.
Now there are either precedent modules or dependent modules of a cash flow statement. The precedent modules of a cash flow statement module refer to the business planning modules that impact the cash position of the underlying business. Examples include revenue, COGS, operating expenses, salaries and wages, debtors, inventory, creditors, fixed assets, debt and equity, tax, other revenues, and expenses, and other balance sheet items.
On the other hand, the dependent modules of a cash flow statement module include primary and secondary modules.
The primary dependent module of a cash flow statement module is a balance sheet module that links the change in cash for each period and adds it to cash at the bank in the current assets section of the balance sheet.
Whereas, the other dependent modules of a cash flow statement link in certain cash flow statement data and use it as a basis for undertaking related analysis. Examples include ordinary equity or valuation modules, enterprise valuation modules, interest on cash modules, etc.
IV. Calculate Key SaaS Metrics
Finally, a SaaS business must build a separate SaaS metrics module that captures the financial data to calculate the key SaaS metrics. A SaaS business can use the Scenario Analysis technique to determine the forecasted data related to each of the metrics.
Some of the key financial metrics that a SaaS business can calculate are showcased in the following table.
|User-Based Metrics||Customer Acquisition Costs|
|Leads & Conversion||Closing Cash|
|Customers & Growth||Customer Acquisition Costs (CAC)|
|New & Renewal Users||CAC / User ($)|
|Churn Rate||LTV / CAC (Months)|
|User-Base Value Metrics|
|Monthly Recurring Revenue|
|EBIT / User ($)|
|Customer LTV ($)|
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