Does Unearned Revenue Affect Working Capital?

A company's balance sheet can show you many different things about the business—an important document if you're considering it as a potential investment. As an investor, you can use the balance sheet to see how much money a company has, as well as how much it owes to its creditors, suppliers, and its customers.

The balance sheet can provide you with a picture of just how healthy a company is from a financial standpoint. Two of the figures you'll want to take a look at are a company's unearned revenue and its working capital. But how does one relate to the other—and do they even have a direct relationship with one another? Read on to learn more about unearned revenue, working capital, and whether the former actually has an impact on the latter.

Unearned Revenue

Unearned revenue typically arises when a company receives compensation but still has to provide products for which the payment was made. Also referred to as deferred revenue, unearned revenue is considered as a form of prepayment, where the purchaser pays for a product or service before actually receiving it. Since payment is already made by the consumer, the supplier has a responsibility to follow through with the delivery when it's ready to do so.

When a company records unearned revenue, it does so as a liability on its balance sheet. That's because the company still owes a debt to the customer in the form of the product or service for which it was paid.

Prepaid services that count as unearned revenue include rent, cable and newspaper subscription services, retainers for legal services, and prepaid insurance. Consider a media company that asks its customers to pay $120 in advance for annual subscriptions to its monthly magazine. When a customer sends a $120 payment, the media company records a $100 debit to its cash balance and a $120 credit to its unearned revenue account. When the company ships magazines to a customer once a month, it can decrease its unearned revenue by $10 by recording a debit to the unearned revenue account and a $10 credit to its revenue account.

There are several modern examples of major tech companies using the unearned revenue account. These are companies that utilize subscription models to sell annual access to services, such as Amazon Prime, Netflix, Spotify, and Dropbox. These tech companies collect payments in advance and deliver the service later. Here's a snapshot of Amazon's unearned revenues as of the second quarter of 2021 (ending June 21, 2021):

Working Capital

Working capital is the difference between a company's current assets and its current liabilities, which it records on its balance sheet. Current assets include things like cash and any receivables, while current liabilities include any bills that a company must pay.

If you want to see how liquid a company is, make sure to take a look at its working capital. This figure measures a company's liquidity as well as its operational efficiency. As such, it's a great indicator of how healthy a business may be in the short term.

So if a company's current assets exceed its current liabilities, it has positive working capital and is, therefore, financially stable. If current liabilities outweigh its current assets—the company may be in trouble as it doesn't have enough cash to meet its financial obligations.

Say a company has a balance of unearned revenue for services it intends to provide within a year, this balance is considered a current liability and would decrease the working capital.

How Unearned Revenue Affects Working Capital

Since unearned revenue represents a company's current liability, it has a direct impact on a company's working capital. It actually decreases this financial figure. Here's how unearned revenue affects working capital.

Unearned revenue is recorded when a firm receives a cash advance from its customer in exchange for products and services that are to be provided in the future. Because a company cannot recognize revenue on this cash advance and because it owes money to a customer, it must record a current liability for any portion of the cash advance for which it expects to provide services within a year. Since current liabilities are part of the working capital, a current balance of unearned revenue reduces a company's working capital.

There is a problem for companies that do not make any adjustments on their balance sheets for unearned revenue or current liabilities. By not doing so, a company overestimates its working capital, which could later cause issues by creating cash flow problems.