As a continuation of the prior article on recurring revenue waterfalls, this piece will provide additional details that business owners and investors can use when analyzing a company’s financial standing. These elements will not always be available nor are they relevant for all companies, but when present, can help increase the granularity and accuracy of financial reporting. Therefore, it is important to consider adding these details when possible to improve the precision of a company’s respective revenue waterfalls. Let’s explore each of these additions in the following sections.
Backlog: What is it and Why is it Important?
For software and SaaS businesses, backlog is an essential to monitor, as it can provide incremental detail on a company’s expectations for future financial performance. In its simplest form, backlog represents the total economic value of bookings from customers under contract that have yet to be implemented and/or recognized as revenue. Backlog not only includes the full value of recurring revenue that has yet to be implemented and recognized as revenue, but also includes the corresponding value from non-recurring streams, such as services. Whenever a customer is signed and its contract value hits a company’s bookings totals, backlog is created if the total value of the customer booking is not yet fully recognized as revenue. This is typically due to the implementation of part / all of the customer’s purchased product being incomplete.
Although backlog may seem similar in nature to deferred revenue, it is important to understand the key differences between the two metrics. First and foremost, backlog, like bookings, is a reporting metric monitored by companies and does not show up on any of the financial statements (whereas deferred revenue is a line item on the balance sheet). Additionally, backlog is dependent only on revenue recognition (i.e. how much of a company’s bookings are not yet recognized as revenue), not on cash collections and billings. On the other, deferred revenue is driven off of billings and invoicing, as it shows up on the balance sheet as soon as a company begins to bill / invoice customers and the deferred revenue balance declines over time as revenue is recognized.
Companies may choose to include backlog as an additional item in its recurring revenue waterfalls, as it conveys the remaining economic value that a company is expected to recognize as revenue over time. It is important only to include the recurring value of backlog in a waterfall, not the full value (which would include non-recurring revenue from services as mentioned previously). Furthermore, one must ensure that the revenue waterfall represented only includes the activated value of revenue and not the booked value. This is due to the fact that the inclusion of backlog in a booked revenue waterfall would double count the value of unrecognized revenue (given that booked revenue inherently includes all of the value of bookings). The below example displays how backlog can be an additional item in a company’s recurring revenue waterfall:
Providing the incremental detail with backlog specifically called out and highlighted in the recurring revenue waterfall provides a clearer, more distinct picture for internal and external stakeholders. This granularity also improves financial reporting understandability and increases insight into a company’s key financial and operational trends, which can ultimately lead to more timely business decisions (e.g. hire more implementation reps to take down large backlog balances).
The Inclusion of Potential / At-Risk Churn
One consistent theme that comes up across clients I have worked with is having the ability to more accurately forecast and predict performance. While using historical trends, correlations and datapoints can be a great foundational start for indicators on forward expectations, the business world is very complex and ever-evolving, requiring the inclusion of additional inputs. The inclusion of incremental detail such as potential / at-risk churn within a revenue waterfall can provide a more precise (and conservative) view of expected performance. Potential / at-risk churn represents the economic value of customers that are currently under contract that have either informed the company that they may be churning in the immediate future or are identified by the company as customers that are at-risk to churn over the near-term. This mechanism can help de-risk the recurring revenue value disclosed by a company in any given period, providing the team with cushion to achieve projected results. Additionally, implementing potential / at-risk churn as a financial reporting and control mechanism creates more frequent, real-time interaction with the existing customer base, allowing the company to learn more about how they can continue to improve the overall customer and user experience, thereby reducing customer churn and risk of cancellations.
The below provides an example on how potential / at-risk churn can be conveyed across both a booked annual recurring revenue waterfall, as well as a monthly recognized recurring revenue waterfall:
The recurring revenue values shown with the inclusion of potential / at-risk churn are lower, which provides a tempered view of expected performance. Additionally, as is evident in months 3, 6 and 10, Company ABC experienced actual churn from customers that were listed as at-risk customers in prior periods, which further proves the usefulness of such a tool within a company’s reporting arsenal.
The “All Other” Bucket in Revenue Waterfalls
When constructing and maintaining a recurring revenue waterfall, one additional item worth including is an “All Other” line. This line item typically is a combination of a variety of things that affect a company’s recurring revenue base, but do not necessarily map to another line item in the waterfall. Representative examples of items that can fall into the “All Other” bucket include credits and refunds, catch-up and prior period adjustments, foreign exchange rate adjustments (for those companies that operate internationally) and other modifications to the recurring revenue base that occur infrequently. The treatment of these line items in both a company’s booked revenue waterfall and recognized revenue waterfall is simple: the company should record one-time adjustments in the All Other line item in the same period they occur (even if the adjustments are discovered much later for a period that has passed, a company should restate the prior period(s) with the necessary All Other adjustments). This ensures consistency and comparability between reporting periods and provides an accurate view on what the value of the recurring revenue should have been in the time period with the proper adjustment added in. By keeping these types of charges and adjustments separate from the other primary components of a revenue waterfall, a company can ensure that one-time items are treated and shown separately, as stripping them out will allow for clearer explanations to internal and external stakeholders.
Concluding Thoughts: Improve the Granularity of Revenue Waterfalls with Incremental Datapoints
When additional detail is available, such as backlog, potential / at-risk churn and one-time adjustments, it is recommended that companies include these in recurring revenue waterfalls to bolster reporting. These incremental datapoints can not only improve the quality of reporting, but also allow for easier explanations and enhanced standalone understandability of financial data. Although not every business is affected by any and/or all of these nuanced items, understanding each of them can provide business owners and investors with a roadmap on how to implement such additions when they arise / become relevant in the future.